Financial
Institutions
Management
A Risk Management Approach
The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate
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Financial
Institutions
Management
A Risk Management Approach
Eighth Edition
Anthony Saunders
John M. Schiff Professor of Finance
Salomon Center
Stern School of Business
New York University
Marcia Millon Cornett
Professor of Finance
Bentley University
FINANCIAL INSTITUTIONS MANAGEMENT: A RISK MANAGEMENT APPROACH,
EIGHTH EDITION
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2014
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Library of Congress Cataloging-in-Publication Data
Saunders, Anthony, 1949Financial institutions management : a risk management approach/Anthony Saunders, John M.
Schiff Professor of Finance, Salomon Center, Stern School of Business, New York University, Marcia
Millon Cornett, Professor of Finance, Bentley University.—Eighth edition.
pages cm
ISBN 978-0-07-803480-0 (alk. paper)
1. Financial institutions—United States—Management. 2. Risk management—United States.
3. Financial services industry—United States—Management. I. Cornett, Marcia Millon. II. Title.
HG181.S33 2014
332.1068—dc23
2013018782
The Internet addresses listed in the text were accurate at the time of publication. The inclusion
of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and
McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.
www.mhhe.com
To all my co-authors over the years.
Anthony Saunders
To my parents, Tom and Sue.
Marcia Millon Cornett
About the Authors
Anthony Saunders
Anthony Saunders is the John M. Schiff Professor of Finance and the former Chair
of the Department of Finance at the Stern School of Business at New York University. Professor Saunders received his PhD from the London School of Economics and has taught both undergraduate- and graduate-level courses at NYU since
1978. Throughout his academic career, his teaching and research have specialized
in financial institutions and international banking. He has served as a visiting professor all over the world, including INSEAD, the Stockholm School of Economics,
and the University of Melbourne.
Professor Saunders has held positions on the Board of Academic Consultants of
the Federal Reserve Board of Governors as well as the Council of Research Advisors for the Federal National Mortgage Association. In addition, Dr. Saunders has
acted as a visiting scholar at the Comptroller of the Currency and at the Federal
Reserve Banks of Philadelphia and New York. Currently, he is an academic consultant for the FDIC. He also held a visiting position in the research department of
the International Monetary Fund. He is editor of Financial Markets, Instruments and
Institutions. His research has been published in all the major money and banking
and finance journals and in several books. In addition, he has authored or coauthored several professional books, the most recent of which is Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms, 3rd edition, John Wiley
and Sons, New York, 2010. In 2008, he was ranked as the most published author in
the last 50 years in the top seven journals in finance.
Marcia Millon Cornett
Marcia Millon Cornett is a Professor of Finance at Bentley University. She received
her BS degree in Economics from Knox College in Galesburg, Illinois, and her MBA
and PhD degrees in Finance from Indiana University in Bloomington, Indiana.
Dr. Cornett has written and published several articles in the areas of bank performance, bank regulation, and corporate finance. Articles authored by Dr. Cornett
have appeared in such academic journals as the Journal of Finance, the Journal of
Money, Credit and Banking, the Journal of Financial Economics, Financial Management, and the Journal of Banking and Finance. In 2008, she was ranked as the 124th
most published author in the last 50 years in the top seven journals in finance.
Dr. Cornett served as an Associate Editor of Financial Management and is currently an Associate Editor for the Journal of Banking and Finance, Journal of Financial
Services Research, FMA Online, the Multinational Finance Journal, and the Review of
Financial Economics. She has served as a member of the Board of Directors, the
Executive Committee, and the Finance Committee of the SIU Credit Union. Dr.
Cornett has also taught at the University of Colorado, Boston College, Southern
Methodist University, and Southern Illinois University at Carbondale. She is a
member of the Financial Management Association, the American Finance Association, and the Western Finance Association.
vi
Preface
The last 25 years have been dramatic for the financial services industry. In the
1990s and 2000s boundaries between the traditional industry sectors, such as
commercial banking and investment banking, broke down, and competition
became increasingly global in nature. Many forces contributed to this breakdown
in interindustry and intercountry barriers, including financial innovation, technology, taxation, and regulation. Then in 2008–09, the financial services industry
experienced the worst financial crisis since the Great Depression. Even into the
mid-2010s, the U.S. and world economies have not recovered from this crisis. It
is in this context that this book is written. Although the traditional nature of each
sector’s product activity is analyzed, a greater emphasis is placed on new areas
of activities such as asset securitization, off-balance-sheet banking, international
banking, and on changes occurring as a result of the financial crisis.
When the first edition of this text was released in 1994, it was the first to analyze
modern financial institutions management from a risk perspective. Thus, the title,
Financial Institutions Management: A Modern Perspective. At that time, traditional
texts presented an overview of the industry sector by sector, concentrating on balance sheet presentations and overlooking management decision making and risk
management. Over the last 20 years other texts have followed this change, such
that a risk management approach to analyzing modern financial institutions is
now well accepted. Thus, the title: Financial Institutions Management: A Risk Management Approach.
The eighth edition of this text takes the same innovative approach taken in the
first seven editions and focuses on managing return and risk in modern financial
institutions (FIs). Financial Institutions Management’s central theme is that the risks
faced by FI managers and the methods and markets through which these risks are
managed are similar whether an institution is chartered as a commercial bank, a
savings bank, an investment bank, or an insurance company.
As in any stockholder-owned corporation, the goal of FI managers should
always be to maximize the value of the financial institution. However, pursuit of
value maximization does not mean that risk management can be ignored.
Indeed, modern FIs are in the risk management business. As we discuss in this
book, in a world of perfect and frictionless capital markets, FIs would not exist
and individuals would manage their own financial assets and portfolios. But since
real-world financial markets are not perfect, FIs provide the positive function of
bearing and managing risk on behalf of their customers through the pooling of
risks and the sale of their services as risk specialists.
INTENDED AUDIENCE
Financial Institutions Management: A Risk Management Approach is aimed at upperlevel undergraduate and MBA audiences. Occasionally there are more technical
sections. These sections may be included or dropped from the chapter reading, depending
on the rigor of the course, without harming the continuity of the chapters.
vii
viii
Preface
MAIN FEATURES
Throughout the text, special features have been integrated to encourage student
interaction with the text and to aid in absorbing the material. Some of these features include:
• In-chapter Internet Exercises and references, which detail instructions for
accessing important recent financial data online.
• International material highlights, which call out material relating to global
issues.
• In-chapter Examples, which provide numerical demonstrations of the analytics described in various chapters.
• Bold key terms and marginal glossary, which highlight and define the main
terms and concepts throughout the chapter.
• In-chapter Concept Questions, which allow students to test themselves on the
main concepts within each major chapter section.
• Notable Events from the Financial Crisis, Industry Perspectives, and After
the Crisis boxes, which demonstrate the application of chapter material to real
current events.
ORGANIZATION
Since our focus is on return and risk and the sources of that return and risk, this
book relates ways in which the managers of modern FIs can expand return with a
managed level of risk to achieve the best, or most favorable, return-risk outcome
for FI owners.
Chapter 1 introduces the special functions of FIs and takes an analytical look at
how financial intermediation benefits today’s economy. Chapters 2 through 6 provide an overview describing the key balance sheet and regulatory features of the
major sectors of the U.S. financial services industry. We discuss depository institutions in Chapter 2, finance companies in Chapter 3, securities firms and investment
banks in Chapter 4, mutual funds and hedge funds in Chapter 5, and insurance
institutions in Chapter 6. In Chapter 7 we preview the risk measurement and management sections with an overview of the risks facing a modern FI. We divide the
chapters on risk measurement and management into two sections: measuring risk
and managing risk.
In Chapters 8 and 9, we start the risk measurement section by investigating the
net interest margin as a source of profitability and risk, with a focus on the effects
of interest rate volatility and the mismatching of asset and liability durations on
FI risk exposure. In Chapter 10, we look at the measurement of credit risk on individual loans and bonds and how this risk adversely affects an FI’s profits through
losses and provisions against the loan and debt security portfolio. In Chapter 11,
we look at the risk of loan (asset) portfolios and the effects of loan concentrations
on risk exposure. In addition, as a by-product of the provision of their interest rate
and credit intermediation services, FIs face liquidity risk. We analyze the special
nature of this risk in Chapter 12.
Modern FIs do more than domestic maturity mismatching and credit extensions. They also are increasingly engaging in foreign exchange activities and
overseas financial investments (Chapter 13) and engaging in sovereign lending
and securities activities (Chapter 14). In Chapter 15, we analyze market risk, a
Preface
ix
risk incurred by FIs in trading assets and liabilities due to changes in interest
rates, exchange rates, and other asset prices.
In addition, modern FIs do more than generate returns and bear risk through
traditional maturity mismatching and credit extensions. They also are increasingly engaging in off-balance-sheet activities to generate fee income (Chapter 16)
and making technological investments to reduce costs (Chapter 17). Each of these
has implications for the size and variability of an FI’s profits and/or revenues.
In Chapter 18 we begin the risk management section by looking at ways in
which FIs can insulate themselves from liquidity risk. In Chapter 19 we look at the
key role deposit insurance and other guaranty schemes play in reducing liquidity risk. At the core of FI risk insulation is the size and adequacy of the owners’
capital or equity investment in the FI, which is the focus of Chapter 20. Chapter 21
analyzes how and why product and geographic diversification—both domestic
and international—can improve an FI’s return-risk performance and the impact of
regulation on the diversification opportunity set. Chapters 22 through 26 review
various new markets and instruments that have been innovated or engineered to
allow FIs to better manage three important types of risk: interest rate risk, credit
risk, and foreign exchange risk. These markets and instruments and their strategic
use by FIs include futures and forwards (Chapter 22); options, caps, floors, and
collars (Chapter 23); swaps (Chapter 24); loan sales (Chapter 25); and securitization (Chapter 26).
CHANGES IN THIS EDITION
Each chapter in this edition has been revised thoroughly to reflect the most upto-date information available. End-of-chapter questions and problem material
have also been expanded and updated to provide a complete selection of testing
material.
The following are some of the new features of this revision:
• Tables and figures in all chapters have been revised to include the most recently
available data.
• New boxes highlighting significant events occurring “After the Crisis” have
been added to chapters throughout the book.
• Integrated Minicases have been added to Chapters 9, 13, 16, and 24.
• Updates on the major changes proposed for the regulation of financial institutions are included where appropriate throughout the book.
• Discussion of how financial institutions continue to recover from the financial
crisis has been added throughout the book. Virtually every chapter includes
new material detailing how the financial crisis has affected risk management in
financial institutions.
• Chapters 2, 7, and 14 include discussions of the European debt crisis as it affects
the risk and return of financial institutions.
• Chapter 2 includes a discussion of Bank Transfer Day, as well as a summary of
the new stress tests imposed on large depository institutions.
• A section on venture capital services has been added to Chapter 5. Also, the
chapter includes a discussion of the LIBOR scandal that broke in late 2012.
• Chapter 5 includes a new section on index funds and expanded discussion of
ETFs. Further, the chapter includes an update on the regulation of hedge funds.
x
Preface
• An actual interest rate sensitivity report for a depository institution has been
added to Chapter 8, and actual duration gap numbers for several banks have
been added to Chapter 9.
• Detailed discussion and examples of the new international liquidity standards
enacted as a result of the financial crisis have been added to Chapter 12.
• Chapter 13 includes a discussion of the pegging of the Swiss franc to the euro in
September 2011.
• Chapter 14 now includes a discussion of the Euromoney Credit Risk measure.
This credit risk measure is then used in Chapter 20 as it applies to the new capital standards being phased in at depository institutions.
• Chapter 15 includes a discussion and examples of the newest market risk measures enacted as a result of the financial crisis. The chapter also discusses the
changes made to market risk measures as a result of Basel 2.5 and Basel III.
• Chapter 16 includes a discussion of the losses incurred by J.P. Morgan Chase
from derivative trading by the “London Whale.”
• Chapter 17 includes a new section on advanced technologies in banking and
additional discussion of several recent technology related losses incurred
by FIs.
• Chapter 18 includes extensive discussion and examples of the new insurance
premium system used by depository institutions.
• Chapter 20 includes a discussion of Basel III capital adequacy rules. The major
changes are described in detail. Many in-chapter and EOC problems have been
added to the chapter to illustrate the many and complex changes to capital adequacy calculations.
• Chapter 21 includes a new section on shadow banks. The chapter also provides
an update on implementation of the Wall Street Reform and Consumer Protection Act enacted as a result of the financial crisis.
• Chapter 26 includes a new section on synthetic CDOs.
We have retained and updated these features:
• The risk approach of Financial Institutions Management has been retained, keeping the first section of the text as an introduction and the last two sections as a
risk measurement and risk management summary, respectively.
• We again present a detailed look at what is new in each of the different sectors of the financial institutions industry in the first six chapters of the text.
We have highlighted the continued international coverage with a global issues
icon throughout the text.
• Chapter 17 includes material on electronic technology and the Internet’s impact
on financial services. Technological changes occurring over the last two decades
have changed the way financial institutions offer services to customers, both
domestically and overseas. The effect of technology is also referenced in other
chapters where relevant.
• Coverage of credit risk models (including newer models, such as Moody’s
Analytics, CreditMetrics, and CreditRisk) remains in the text.
• Coverage in the “Product and Geographic Expansion” chapter explores the
increased inroads of banks into the insurance field, the move toward nationwide banking (in the United States), and the rapid growth of foreign banks and
other intermediaries in the United States.
Preface
xi
• Numerous highlighted in-chapter Examples remain in the chapters.
• Internet references remain throughout each chapter and Internet questions are
found after the end-of-chapter questions.
• An extensive problem set, including web exercises, can be found at the end of
each chapter that allows students to practice a variety of skills using the same
data or set of circumstances.
ANCILLARIES
All supplemental materials for both students and instructors can be found on the
McGraw-Hill website for the eighth edition of Financial Institutions Management
at www.mhhe.com/saunders8e. Instructor materials are password-protected for
your security.
Print versions are available by request only—if interested, please contact your
McGraw-Hill/Irwin representative. The following supplements are available for
the eighth edition.
For Students
• Multiple-Choice Quizzes for each chapter consist of 10 multiple-choice questions that reflect key concepts from the text. These quizzes have instant grading.
• Appendices consist of material that has been removed from previous editions of
the print textbook to allow room for new topics.
For Instructors
• The Test Bank, created by Thomas Secrest of Coastal Carolina University, offers
multiple-choice and true/false questions that are designed to apply specifically
to this text and this edition’s revisions. The Test Bank is available in Word document format and EZ Test online.
• The Instructor’s Manual, created by author Marcia Millon Cornett, contains
answers to the text’s Questions and Problems at the end of each chapter and
chapter outlines.
• The PowerPoint Presentations summarize the main points of each chapter in a
step-by-step fashion. These slideshows can be edited by instructors to customize presentations.
• The Digital Image Library contains electronic versions of all figures and tables
from the seventh edition of the text.
CourseSmart is a new way for faculty to find and review eTextbooks. It’s also a
great option for students who are interested in accessing their course materials
digitally. CourseSmart offers thousands of the most commonly adopted textbooks
across hundreds of courses from a wide variety of higher education publishers.
It is the only place for faculty to review and compare the full text of a textbook
online. At CourseSmart, students can save up to 50 percent off the cost of a print
book, reduce their impact on the environment, and gain access to powerful web
tools for learning including full text search, notes and highlighting, and email
tools for sharing notes between classmates. Your eBook also includes tech support
in case you ever need help.
Finding your eBook is easy. Visit www.CourseSmart.com and search by title,
author, or ISBN.
Acknowledgments
Finally, we would like to thank the numerous colleagues who assisted with the
previous editions of this book. Of great help were the book reviewers whose
painstaking comments and advice guided the text through its seven revisions.
Jack Aber
Boston University
Brian J. Adams
University of Portland
Michael H. Anderson
Suffolk University
Mounther Barakat
University of Houston–Clear Lake
Sreedhar Bharath
University of Michigan
Rita Biswas
SUNY–Albany
M. E. Bond
University of Memphis
Qiang Bu
Pennsylvania State–Harrisburg
Yea-Mow Chen
San Francisco State University
Jeffrey A. Clark
Florida State University
Robert A. Clark
Butler University
S. Steven Cole
University of North Texas
Douglas Cook
University of Mississippi
Kenneth Daniels
Virginia Commonwealth University
Paul Ellinger
University of Illinois
David Ely
San Diego State University
Joseph Finnerty
University of Illinios
Jack Clark Francis
Baruch College–CUNY
James H. Gilkeson
University of Central Florida
xii
Anurag Gupta
Case Western Reserve University
John H. Hand
Auburn University
Yan He
San Francisco State University
Alan C. Hess
University of Washington–Seattle
Ray Jackson
University of Massachusetts–Dartmouth
Kevin Jacques
Georgetown University and Office of the
Comptroller of the Currency
Julapa Jagtiani
Federal Reserve Bank of Chicago
Craig G. Johnson
California State University–Hayward
Nelson J. Lacey
University of Massachusetts at Amherst
Robert Lamy
Wake Forest University
Rick LeCompte
Wichita State University
Barry Marchman
Georgia Institute of Technology
Patricia C. Matthews
Mount Union College
Robert McLeod
University of Alabama
Jamie McNutt
Rutgers–Camden
Ardavan Mobasheri
Bernard M. Baruch College–CUNY
Richard Patterson
Indiana University
Roberto Perli
University of Maryland
Acknowledgments
Rose M. Prasad
Central Michigan University
Andreas Rauterkus
University of Alabama–Birmingham
Kenneth Rhoda
LaSalle University
Tara Rice
Boston College
Don Sabbarese
Kennesaw State University
Daniel Singer
Towson University
Richard Stolz
California State University–Fullerton
xiii
Michael Toyne
Northeastern State University
Haluk Unal
University of Maryland
James A. Verbrugge
University of Georgia
Hsinrong Wei
Baruch College–CUNY
Sonya Williams-Stanton
University of Michigan–Ann Arbor
Robert Wolf
University of Wisconsin–La Crosse
In addition, we gratefully acknowledge the contributions of the reviewers of the
seventh edition:
Ethan Cohen-Cole
University of Maryland–College Park
James Conover
University of North Texas
Elyas Elyasiani
Temple University–Philadelphia
Margaret Forster
University of Notre Dame
Deniz Kebabci Tudor
San Francisco State University
Elinda Kiss
University of Maryland–College Park
Richard Patterson
Indiana University–Bloomington
Joe Peek
University of Kentucky–Lexington
Marcelo Pinheiro
George Mason University
Alexander Wilson
University of Arizona
Shaorong Zhang
Marshall University
Lina Zhou
Augustana College
We very much appreciate the contributions of the book team at McGraw-Hill
Education: Chuck Synovec, Executive Brand Manager; Noelle Bathurst, Development Editor; Melissa Caughlin, Senior Marketing Manager; and Judi David, Content Project Manager. We are also grateful to our secretaries and assistants, Robyn
Vanterpool, Ingrid Persaud, Anand Srinivasan, Brenda Webb, and Sharon Moore.
Anthony Saunders
Marcia Millon Cornett
Brief Contents
PART ONE
13 Foreign Exchange Risk
Introduction 1
14 Sovereign Risk
1 Why Are Financial Institutions
Special? 2
2 Financial Services: Depository
Institutions 25
3 Financial Services: Finance
Companies 68
4 Financial Services: Securities
Brokerage and Investment
Banking 84
5 Financial Services: Mutual Funds
and Hedge Funds 111
6 Financial Services: Insurance 148
7 Risks of Financial Institutions 173
PART TWO
Measuring Risk
9 Interest Rate Risk II
196
226
10 Credit Risk: Individual Loan
Risk 274
11 Credit Risk: Loan Portfolio
and Concentration Risk 326
12 Liquidity Risk
xiv
351
412
438
16 Off-Balance-Sheet Risk
474
17 Technology and Other Operational
Risks 503
PART THREE
Managing Risk
537
18 Liability and Liquidity
Management 538
19 Deposit Insurance and Other
Liability Guarantees 568
20 Capital Adequacy
605
21 Product and Geographic
Expansion 651
22 Futures and Forwards
195
8 Interest Rate Risk I
15 Market Risk
383
23 Options, Caps, Floors,
and Collars 728
24 Swaps
766
25 Loan Sales
796
26 Securitization 812
Index
856
691
Contents
PART ONE
Other Fee-Generating Activities
Regulation 39
Industry Performance 44
INTRODUCTION 1
Savings Institutions
Chapter One
Why Are Financial Institutions
Special? 2
Introduction 2
Financial Institutions’ Specialness
FIs Function as Brokers 5
FIs Function as Asset Transformers
Information Costs 6
Liquidity and Price Risk 7
Other Special Services 8
Other Aspects of Specialness
Credit Unions
4
10
15
15
Appendix 1A
The Financial Crisis: The Failure of Financial
Services Institution Specialness
(www.mhhe.com/saunders8e)
Appendix 1B
Monetary Policy Tools
(www.mhhe.com/saunders8e)
27
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends 32
Chapter Three
Financial Services: Finance
Companies 68
Introduction 68
Size, Structure, and Composition of the
Industry 68
Balance Sheet and Recent Trends 72
Assets 72
Liabilities and Equity
Industry Performance
Regulation 80
Global Issues 82
Chapter Two
Financial Services: Depository
Institutions 25
Introduction 25
Commercial Banks
55
Global Issues: The Financial Crisis 60
Appendix 2A
Financial Statement Analysis Using a Return on
Equity (ROE) Framework
(www.mhhe.com/saunders8e)
Appendix 2B
Commercial Banks’ Financial Statements
and Analysis
(www.mhhe.com/saunders8e)
Appendix 2C
Depository Institutions and Their Regulators
(www.mhhe.com/saunders8e)
Appendix 2D
Technology in Commercial Banking
(www.mhhe.com/saunders8e)
8
Safety and Soundness Regulation 11
Monetary Policy Regulation 13
Credit Allocation Regulation 13
Consumer Protection Regulation 13
Investor Protection Regulation 14
Entry Regulation 14
Trends in the United States
Global Trends 20
48
55
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends 57
Regulation 59
Industry Performance 59
5
The Changing Dynamics of Specialness
48
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends 50
Regulation 52
Industry Performance 52
The Transmission of Monetary Policy 8
Credit Allocation 9
Intergenerational Wealth Transfers or Time
Intermediation 9
Payment Services 9
Denomination Intermediation 10
Specialness and Regulation
38
28
77
78
Chapter Four
Financial Services: Securities Brokerage
and Investment Banking 84
Introduction 84
xv
xvi
Contents
Size, Structure, and Composition of the
Industry 86
Balance Sheet and Recent Trends 96
Liquidity Risk 178
Foreign Exchange Risk 180
Country or Sovereign Risk 182
Market Risk 183
Off-Balance-Sheet Risk 185
Technology and Operational Risks 186
Insolvency Risk 188
Other Risks and the Interaction of Risks 189
Recent Trends 96
Balance Sheet 99
Regulation 101
Global Issues 104
Chapter Five
Financial Services: Mutual Funds
and Hedge Funds 111
PART TWO
MEASURING RISK
Introduction 111
Size, Structure, and Composition of the Mutual
Fund Industry 112
Historical Trends 112
Different Types of Mutual Funds 115
Mutual Fund Objectives 119
Investor Returns from Mutual Fund Ownership
Mutual Fund Costs 125
122
Balance Sheet and Recent Trends for the Mutual
Fund Industry 128
Money Market Funds 128
Long-Term Funds 130
134
Types of Hedge Funds 138
Fees on Hedge Funds 142
Offshore Hedge Funds 143
Regulation of Hedge Funds 143
Chapter Six
Financial Services: Insurance
148
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends 153
Regulation 156
Rate-Sensitive Assets 201
Rate-Sensitive Liabilities 202
Equal Changes in Rates on RSAs and RSLs 204
Unequal Changes in Rates on RSAs and RSLs 205
168
Chapter Seven
Risks of Financial Institutions
Market Value Effects 208
Overaggregation 209
The Problem of Runoffs 209
Cash Flows from Off-Balance-Sheet Activities
173
210
219
Chapter Nine
Interest Rate Risk II 226
149
157
Size, Structure, and Composition of the Industry
Balance Sheet and Recent Trends 159
Regulation 168
Introduction 173
Interest Rate Risk 174
Credit Risk 176
Introduction 196
The Level and Movement of Interest Rates 197
The Repricing Model 199
Appendix 8A
The Maturity Model
(www.mhhe.com/saunders8e)
Appendix 8B
Term Structure of Interest Rates
Introduction 148
Life Insurance 149
Global Issues
196
Weaknesses of the Repricing Model 208
Regulation of Mutual Funds 131
Global Issues in the Mutual Fund Industry
Hedge Funds 136
Property–Casualty Insurance
Chapter Eight
Interest Rate Risk I
195
157
Introduction 226
Duration: A Simple Introduction 227
A General Formula for Duration 229
The Duration of Interest-Bearing Bonds 231
The Duration of Zero-Coupon Bonds 233
The Duration of Consol Bonds (Perpetuities) 233
Features of Duration
234
Duration and Maturity 234
Duration and Yield 235
Duration and Coupon Interest 235
The Economic Meaning of Duration
Semiannual Coupon Bonds
236
240
Duration and Interest Rate Risk
241
Duration and Interest Rate Risk Management
on a Single Security 241
Contents xvii
Duration and Interest Rate Risk Management on the
Whole Balance Sheet of an FI 244
Loan Portfolio Diversification and Modern
Portfolio Theory (MPT) 328
Immunization and Regulatory
Considerations 251
Difficulties in Applying the Duration
Model 252
Duration Matching Can Be Costly 252
Immunization Is a Dynamic Problem 252
Large Interest Rate Changes and Convexity
Moody’s Analytics Portfolio Manager Model 331
Partial Applications of Portfolio Theory 335
Regulatory Models 339
Appendix 11A
CreditMetrics 345
Appendix 11B
CreditRisk 348
253
Appendix 9A
The Basics of Bond Valuation
(www.mhhe.com/saunders8e)
Appendix 9B
Incorporating Convexity into the Duration
Model 264
Chapter Ten
Credit Risk: Individual Loan Risk
Introduction 274
Credit Quality Problems
Types of Loans 278
Chapter Twelve
Liquidity Risk 351
Introduction 351
Causes of Liquidity Risk 352
Liquidity Risk at Depository Institutions
274
276
Commercial and Industrial Loans 278
Real Estate Loans 280
Individual (Consumer) Loans 282
Other Loans 284
Calculating the Return on a Loan 284
The Contractually Promised Return on a Loan
The Expected Return on a Loan 288
Retail versus Wholesale Credit Decisions
284
289
Retail 289
Wholesale 289
Measurement of Credit Risk
Default Risk Models 292
291
Qualitative Models 292
Quantitative Models 294
Newer Models of Credit Risk Measurement
and Pricing 298
Liquidity Risk and Life Insurance Companies 370
Liquidity Risk and Property–Casualty
Insurers 370
Investment Funds 371
Appendix 12A
Sources and Uses of Funds Statement, Bank of
America, March 2012
(www.mhhe.com/saunders8e)
Appendix 12B
Illustrative Template for the LCR 380
Chapter Thirteen
Foreign Exchange Risk 383
Appendix 10A
Credit Analysis
(www.mhhe.com/saunders8e)
Appendix 10B
Black–Scholes Option Pricing Model
(www.mhhe.com/saunders8e)
Introduction 383
Foreign Exchange Rates and Transactions
Foreign Exchange Rates 383
Foreign Exchange Transactions
383
384
Sources of Foreign Exchange Risk Exposure 387
Foreign Exchange Rate Volatility and FX Exposure
389
Foreign Currency Trading 390
Chapter Eleven
Credit Risk: Loan Portfolio
and Concentration Risk 326
Introduction 326
Simple Models of Loan Concentration Risk
352
Liability-Side Liquidity Risk 352
Asset-Side Liquidity Risk 356
Measuring a DI’s Liquidity Risk Exposure 358
New Liquidity Risk Measures Implemented by the Bank
for International Settlements 361
Liquidity Risk, Unexpected Deposit Drains, and Bank
Runs 368
Bank Runs, the Discount Window, and Deposit
Insurance 369
FX Trading Activities
391
Foreign Asset and Liability Positions 392
326
The Return and Risk of Foreign Investments 393
Risk and Hedging 395
Multicurrency Foreign Asset–Liability Positions 399
xviii
Contents
Interaction of Interest Rates, Inflation,
and Exchange Rates 400
Returns and Risks of Off-Balance-Sheet
Activities 479
Purchasing Power Parity 401
Interest Rate Parity Theorem 402
Loan Commitments 481
Commercial Letters of Credit and Standby Letters
of Credit 485
Derivative Contracts: Futures, Forwards, Swaps,
and Options 488
Forward Purchases and Sales of When-Issued
Securities 491
Loans Sold 492
Chapter Fourteen
Sovereign Risk 412
Introduction 412
Credit Risk versus Sovereign Risk
Debt Repudiation versus Debt
Rescheduling 416
Country Risk Evaluation 418
416
Non–Schedule L Off-Balance-Sheet Risks
Outside Evaluation Models 418
Internal Evaluation Models 420
Using Market Data to Measure Risk: The Secondary
Market for LDC and Emerging Market Debt 429
Appendix 14A
Mechanisms for Dealing with Sovereign Risk
Exposure
(www.mhhe.com/saunders8e)
Chapter Fifteen
Market Risk 438
Introduction 438
Calculating Market Risk Exposure
The Risk Metrics Model 441
The Role of OBS Activities in Reducing
Risk 495
Appendix 16A
A Letter of Credit Transaction
(www.mhhe.com/saunders8e)
Chapter Seventeen
Technology and Other Operational
Risks 503
Introduction 503
What are the Sources of Operational Risk? 505
Technological Innovation and Profitability 505
The Impact of Technology on Wholesale
and Retail Financial Service Production 508
440
The Market Risk of Fixed-Income Securities
Foreign Exchange 445
Equities 446
Portfolio Aggregation 447
442
Historic (Back Simulation) Approach 450
The Historic (Back Simulation) Model versus
RiskMetrics 453
The Monte Carlo Simulation Approach 454
Expected Shortfall 458
Regulatory Models: The BIS Standardized
Framework 461
Partial Risk Factor Approach 461
Fuller Risk Factor Approach 462
The BIS Regulations and Large-Bank Internal
Models 465
Chapter Sixteen
Off-Balance-Sheet Risk
493
Settlement Risk 493
Affiliate Risk 494
Wholesale Financial Services 508
Retail Financial Services 509
Advanced Technology Requirements
511
The Effect of Technology on Revenues
and Costs 512
Technology and Revenues 514
Technology and Costs 515
Testing for Economies of Scale and Economies
of Scope 519
The Production Approach 519
The Intermediation Approach 519
Empirical Findings on Cost Economies of Scale
and Scope and Implications for Technology
Expenditures 520
Economies of Scale and Scope and X-Inefficiencies
520
Technology and the Evolution of the Payments
System 522
474
Introduction 474
Off-Balance-Sheet Activities and FI
Solvency 475
Risks That Arise in an Electronic Transfer Payment
System 524
Other Operational Risks 529
Regulatory Issues and Technology
and Operational Risks 531
Contents
PART THREE
MANAGING RISK
The Causes of the Depository Fund
Insolvencies 572
537
Chapter Eighteen
Liability and Liquidity Management
Introduction 538
Liquid Asset Management
The Financial Environment
Moral Hazard 573
538
538
Monetary Policy Implementation Reasons 539
Taxation Reasons 539
The Composition of the Liquid Asset
Portfolio 540
Return-Risk Trade-Off for Liquid Assets
541
The Liquid Asset Reserve Management Problem for U.S.
Depository Institutions 541
Undershooting/Overshooting of the Reserve
Target 545
Managing Liquid Assets Other than Cash 549
Liability Management
Funding Risk and Cost
550
551
Choice of Liability Structure
xix
552
Demand Deposits 552
Interest-Bearing Checking (NOW) Accounts 553
Passbook Savings 554
Money Market Deposit Accounts (MMDAs) 554
Retail Time Deposits and CDs 555
Wholesale CDs 556
Federal Funds 557
Repurchase Agreements (RPs) 558
Other Borrowings 558
Liquidity and Liability Structures for U.S.
Depository Institutions 560
Liability and Liquidity Risk Management
in Insurance Companies 562
Liability and Liquidity Risk Management
in Other Financial Institutions 562
Appendix 18A
Federal Reserve Requirement Accounting
(www.mhhe.com/saunders8e)
Appendix 18B
Bankers’ Acceptances and Commercial Paper as
Sources of Financing
(www.mhhe.com/saunders8e)
Chapter Nineteen
Deposit Insurance and Other
Liability Guarantees 568
Introduction 568
Bank and Thrift Guaranty Funds
572
Panic Prevention versus Moral Hazard 574
Controlling Depository Institution Risk Taking 575
Stockholder Discipline 575
Depositor Discipline 580
Regulatory Discipline 585
Non-U.S. Deposit Insurance Systems
The Discount Window 587
586
Deposit Insurance versus the Discount Window
The Discount Window 587
Other Guaranty Programs
590
National Credit Union Administration 590
Property–Casualty and Life Insurance Companies 590
The Securities Investor Protection Corporation 591
The Pension Benefit Guaranty Corporation 593
Appendix 19A
Calculation of Deposit Insurance
Premiums 600
Appendix 19B
FDIC Press Release of Bank Failures
(www.mhhe.com/saunders8e)
Appendix 19C
Deposit Insurance Coverage for Commercial
Banks in Various Countries
(www.mhhe.com/saunders8e)
Chapter Twenty
Capital Adequacy
605
Introduction 605
Capital and Insolvency Risk 606
Capital 606
The Market Value of Capital 607
The Book Value of Capital 608
The Discrepancy between the Market and Book Values
of Equity 609
Arguments against Market Value Accounting 609
Capital Adequacy in the Commercial Banking
and Thrift Industry 611
Capital 617
Credit Risk–Adjusted Assets 618
Calculating Risk-Based Capital Ratios
618
Capital Requirements for Other Financial
Institutions 636
569
587
Securities Firms 636
Life Insurance 636
Property–Casualty Insurance
638
xx
Contents
Appendix 20A
Internal Ratings-Based Approach to Measuring
Credit Risk-Adjusted Assets 648
Appendix 20B
Methodology Used to Determine G-SIBs’
Capital Surcharge
(www.mhhe.com/saunders8e)
Chapter Twenty-One
Product and Geographic Expansion 651
Introduction 651
Product Diversification 652
Segmentation in the U.S. Financial Services
Industry 653
Commercial and Investment Banking Activities 653
Banking and Insurance 656
Commercial Banking and Commerce 657
Nonbank Financial Service Firms and Banking 658
Nonbank Financial Service Firms and Commerce 660
Activity Restrictions in the United States versus
Other Countries 660
Issues Involved in the Diversification of Product
Offerings 661
Safety and Soundness Concerns 661
Economies of Scale and Scope 663
Conflicts of Interest 664
Deposit Insurance 665
Regulatory Oversight 666
Competition 666
Cost and Revenue Synergies Affecting
Domestic Geographic Expansion by Merger
and Acquisition 672
674
Other Market- and Firm-Specific Factors Affecting
Domestic Geographic Expansion Decisions 677
Global and International Expansions 678
682
Advantages and Disadvantages of International
Expansion 684
Advantages 684
Disadvantages 685
691
Introduction 691
Forward and Futures Contracts
693
Spot Contracts 693
Forward Contracts 693
Futures Contracts 694
Forward Contracts and Hedging Interest Rate
Risk 695
Hedging Interest Rate Risk with Futures
Contracts 697
Microhedging 697
Macrohedging 697
Routine Hedging versus Selective Hedging
Macrohedging with Futures 698
The Problem of Basis Risk 706
Hedging Foreign Exchange Risk
698
708
712
Hedging Credit Risk with Futures
and Forwards 715
Insurance Companies 669
Thrifts 669
Commercial Banks 669
U.S. Banks Abroad 679
Foreign Banks in the United States
Chapter Twenty-Two
Futures and Forwards
Forwards 708
Futures 708
Estimating the Hedge Ratio
Domestic Geographic Expansion 668
Regulatory Factors Affecting Geographic
Expansion 669
Cost Synergies 673
Revenue Synergies 674
Merger Guidelines for Acceptability
Appendix 21A
EU and G-10 Countries: Regulatory Treatment of
the Mixing of Banking, Securities, and Insurance
Activities and the Mixing of Banking and
Commerce
(www.mhhe.com/saunders8e)
Credit Forward Contracts and Credit Risk
Hedging 716
Futures Contracts and Catastrophe Risk 718
Regulation of Derivative Securities
Appendix 22A
Microhedging with Futures
(www.mhhe.com/saunders8e)
718
Chapter Twenty-Three
Options, Caps, Floors, and Collars
Introduction 728
Basic Features of Options
728
728
Buying a Call Option on a Bond 729
Writing a Call Option on a Bond 730
Buying a Put Option on a Bond 731
Writing a Put Option on a Bond 731
Writing versus Buying Options
732
Economic Reasons for Not Writing Options
Regulatory Reasons 734
Futures versus Options Hedging 734
732
Contents
Trends in Loan Sales 800
The Buyers and the Sellers 801
The Mechanics of Hedging a Bond or
Bond Portfolio 735
Why Banks and Other FIs Sell Loans
Hedging with Bond Options Using the Binomial
Model 736
Reserve Requirements
Fee Income 807
Capital Costs 807
Liquidity Risk 807
Actual Bond Options 740
Using Options to Hedge Interest Rate Risk
on the Balance Sheet 742
Using Options to Hedge Foreign Exchange
Risk 747
Hedging Credit Risk with Options 748
Hedging Catastrophe Risk with Call
Spread Options 749
Caps, Floors, and Collars 750
Caps 751
Floors 754
Collars 755
Caps, Floors, Collars, and Credit Risk
xxi
806
806
Factors Affecting Loan Sales Growth 807
Access to the Commercial Paper Market 807
Customer Relationship Effects 808
Legal Concerns 808
BIS Capital Requirements 808
Market Value Accounting 808
Asset Brokerage and Loan Trading 809
Government Loan Sales 809
Credit Ratings 809
Purchase and Sale of Foreign Bank Loans 809
758
Appendix 23A
Microhedging with Options
(www.mhhe.com/saunders8e)
Chapter Twenty-Six
Securitization 812
Chapter Twenty-Four
Swaps 766
Introduction 812
Mechanisms Used to Convert On-Balance-Sheet
Assets to a Securitized Asset 813
The Pass-Through Security 816
Introduction 766
Swap Markets 767
Interest Rate Swaps 768
Realized Cash Flows on an Interest Rate Swap
Macrohedging with Swaps 773
Currency Swaps
772
776
Fixed-Fixed Currency Swaps 776
Fixed-Floating Currency Swaps 778
Credit Swaps
779
Total Return Swaps 781
Pure Credit Swaps 783
CDS Indexes 783
The Collateralized Mortgage Obligation
(CMO) 838
Swaps and Credit Risk Concerns 784
Netting and Swaps 786
Payment Flows Are Interest and Not Principal
Standby Letters of Credit 786
Appendix 24A
Setting Rates on an Interest Rate Swap
Chapter Twenty-Five
Loan Sales 796
Introduction 796
The Bank Loan Sales Market
GNMA 817
FNMA 817
FHLMC 818
The Incentives and Mechanics of Pass-Through
Security Creation 818
Prepayment Risk on Pass-Through Securities 824
Prepayment Models 828
Government Sponsorship and Oversight of FNMA
and Freddie Mac 836
797
Definition of a Loan Sale 797
Types of Loan Sales 797
Types of Loan Sales Contracts 799
786
792
Creation of CMOs 839
Class A, B, and C Bond Buyers
Other CMO Classes 841
841
The Mortgage-Backed Bond (MBB) or
Covered Bond 842
Innovations in Securitization 844
Mortgage Pass-Through Strips 844
Securitization of Other Assets 847
Can All Assets Be Securitized? 848
Appendix 26A
Fannie Mae and Freddie Mac Balance
Sheets
(www.mhhe.com/saunders8e)
INDEX
856
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Part One
Introduction
1. Why Are Financial Institutions Special? 2
2. Financial Services: Depository Institutions 28
3. Financial Services: Finance Companies 68
4. Financial Services: Securities Brokerage and Investment Banking 84
5. Financial Services: Mutual Funds and Hedge Funds 111
6. Financial Services: Insurance 148
7. Risks of Financial Institutions 173
Chapter One
See Appendices Online at www.mhhe.com/saunders8e
• Appendix 1A: The Financial Crisis: The Failure of Financial Institution Specialness
• Appendix 1B: Monetary Policy Tools
Why Are Financial
Institutions Special?
INTRODUCTION
Over the last 90 years, the financial services industry has come full cycle. Originally, the banking industry operated as a full-service industry, performing directly
or indirectly all financial services (commercial banking, investment banking, stock
investing services, insurance providers, etc.). In the early 1930s, the economic and
industrial collapse resulted in the separation of some of these activities. In the
1970s and 1980s, new, relatively unregulated financial services industries sprang
up (mutual funds, brokerage funds, etc.) that separated financial services functions
even further. As we entered the 21st century, regulatory barriers, technology, and
financial innovation changes were such that a full set of financial services could
again be offered by a single financial services firm under the umbrella of a financial
services holding company. For example, J.P. Morgan Chase operates a commercial
bank, J.P. Morgan Chase Bank, an investment bank, J.P. Morgan Securities (which
also sells mutual funds), and an insurance company, J.P. Morgan Insurance Agency.
During the financial crisis, this financial services holding company purchased a
savings institution, Washington Mutual, and several investment banks, including
Bear Stearns. Not only did the boundaries between traditional industry sectors
change, but competition became global in nature as well. For example, J.P. Morgan
Chase is the world’s eighth largest financial services holding company, operating in 60 countries. Then came the late 2000s when the United States and indeed
the world experienced a collapse of financial markets second only to that experienced during the Great Depression. The financial crisis produced a major reshaping of all financial institution (FI) sectors and the end of many major FIs, e.g., Bear
Stearns and Lehman Brothers. The result was a call by the Obama administration
to again separate activities performed by individual FIs.
As the competitive environment changes, attention to profit and, more than
ever, risk becomes increasingly important. The major themes of this book are the
measurement and management of the risks of financial institutions. Financial
institutions (e.g., banks, credit unions, insurance companies, and mutual funds)
perform the essential function of channeling funds from those with surplus funds
2
Chapter 1
Why Are Financial Institutions Special?
3
(suppliers of funds) to those with shortages of funds (users of funds). In 2012,
U.S. FIs held assets totaling more than $28.68 trillion. In contrast, the U.S. motor
vehicle and parts industry (e.g., General Motors and Ford Motor Corp.) held total
assets of $0.48 trillion.
Although we might categorize or group FIs and the services they perform as life
insurance companies, banks, investment banks, and so on, they face many common risks. Specifically, all FIs described in this chapter and Chapters 2 through 6
(1) hold some assets that are potentially subject to default or credit risk and (2) tend
to mismatch the maturities of their balance sheet assets and liabilities to a greater
or lesser extent and are thus exposed to interest rate risk. Moreover, all FIs are
exposed to some degree of liability withdrawal or liquidity risk, depending on
the type of claims they have sold to liability holders. In addition, most FIs are
exposed to some type of underwriting risk, whether through the sale of securities or the issue of various types of credit guarantees on or off the balance sheet.
Finally, all FIs are exposed to operating risks because the production of financial
services requires the use of real resources and back-office support systems (labor
and technology combined to provide services).
Because of these risks and the special role that FIs play in the financial system,
FIs are singled out for special regulatory attention. In this chapter, we first examine questions related to this specialness. In particular, what are the special functions that FIs—both depository institutions (banks, savings institutions, and credit
unions) and nondepository institutions (insurance companies, securities firms,
investment banks, finance companies, and mutual funds)—provide? These functions are summarized in Table 1–1. How do these functions benefit the economy?
Second, we investigate what makes some FIs more special than others. Third, we
look at how unique and long-lived the special functions of FIs really are. As part
of this discussion, we briefly examine how changes in the way FIs deliver services
TABLE 1–1
Areas of Financial Intermediaries’ Specialness in the Provision of Services
Information costs The aggregation of funds in an FI provides greater incentive to collect information about
customers (such as corporations) and to monitor their actions. The relatively large size of the FI allows this collection of information to be accomplished at a lower average cost (so-called economies of scale) than would be the
case for individuals.
Liquidity and price risk FIs provide financial claims to household savers with superior liquidity attributes and with
lower price risk.
Transaction cost services Similar to economies of scale in information production costs, an FI’s size can result in
economies of scale in transaction costs.
Maturity intermediation FIs can better bear the risk of mismatching the maturities of their assets and liabilities.
Transmission of monetary supply Depository institutions are the conduit through which monetary policy actions
by the country’s central bank (the Federal Reserve) impact the rest of the financial system and the economy.
Credit allocation FIs are often viewed as the major, and sometimes only, source of financing for particular sectors of
the economy, such as farming, small business, and residential real estate.
Intergenerational wealth transfers FIs, especially life insurance companies and pension funds, provide savers with
the ability to transfer wealth from one generation to the next.
Payment services The efficiency with which depository institutions provide payment services such as check clearing
directly benefits the economy.
Denomination intermediation FIs, such as mutual funds, allow small investors to overcome constraints to buying
assets imposed by large minimum denomination size.
4
Part One
Introduction
played a major part in the events leading up to the severe financial crisis of the
late 2000s. A more detailed discussion of the causes of, major events during, and
regulatory and industry changes resulting from the financial crisis is provided
in Appendix 1A to the chapter (located at the book’s website, www.mhhe.com/
saunders8e).
FINANCIAL INSTITUTIONS’ SPECIALNESS
liquidity
The ease of converting an asset into cash.
price risk
The risk that the sale
price of an asset will
be lower than the
purchase price of that
asset.
To understand the important economic function of FIs, imagine a simple world
in which FIs do not exist. In such a world, households generating excess savings
by consuming less than they earn would have the basic choice: They could hold
cash as an asset or invest in the securities issued by corporations. In general, corporations issue securities to finance their investments in real assets and cover the
gap between their investment plans and their internally generated savings such as
retained earnings.
As shown in Figure 1–1, in such a world, savings would flow from households
to corporations. In return, financial claims (equity and debt securities) would flow
from corporations to household savers. In an economy without FIs, the level of
fund flows between household savers and the corporate sector is likely to be quite
low. There are several reasons for this. Once they have lent money to a firm by
buying its financial claims, households need to monitor, or check, the actions of
that firm. They must be sure that the firm’s management neither absconds with
nor wastes the funds on any projects with low or negative net present values. Such
monitoring actions are extremely costly for any given household because they
require considerable time and expense to collect sufficiently high-quality information relative to the size of the average household saver’s investments. Given this,
it is likely that each household would prefer to leave the monitoring to others. In
the end, little or no monitoring would be done. The resulting lack of monitoring
would reduce the attractiveness and increase the risk of investing in corporate
debt and equity.
The relatively long-term nature of corporate equity and debt, and the lack of
a secondary market in which households can sell these securities, creates a second disincentive for household investors to hold the direct financial claims issued
by corporations. Specifically, given the choice between holding cash and holding
long-term securities, households may well choose to hold cash for liquidity reasons, especially if they plan to use savings to finance consumption expenditures
in the near future.
Finally, even if financial markets existed (without FIs to operate them) to provide liquidity services by allowing households to trade corporate debt and equity
securities among themselves, investors also face a price risk on sale of securities,
and the secondary market trading of securities involves various transaction costs.
That is, the price at which household investors can sell securities on secondary
markets such as the New York Stock Exchange (NYSE) may well differ from the
price they initially paid for the securities.
FIGURE 1–1
Flow of Funds in a
World without FIs
Equity and debt claims
Households
(net savers)
Corporations
(net borrowers)
Cash
Chapter 1
Why Are Financial Institutions Special?
5
Because of (1) monitoring costs, (2) liquidity costs, and (3) price risk, the average
household saver may view direct investment in corporate securities as an unattractive proposition and prefer either not to save or to save in the form of cash.
However, the economy has developed an alternative and indirect way to channel household savings to the corporate sector. This is to channel savings via FIs.
Because of costs of monitoring, liquidity, and price risk, as well as for some other
reasons, explained later, savers often prefer to hold the financial claims issued
by FIs rather than those issued by corporations. Consider Figure 1–2, which is a
closer representation than Figure 1–1 of the world in which we live and the way
funds flow in our economy. Notice how financial institutions or intermediaries are
standing, or intermediating, between the household and corporate sectors. These
intermediaries fulfill two functions; any given FI might specialize in one or the
other or might do both simultaneously.
FIs Function as Brokers
economies of scale
The concept that the
cost reduction in trading and other transaction services results
in increased efficiency
when FIs perform
these services.
asset transformer
An FI issues financial
claims that are more
attractive to household savers than the
claims directly issued
by corporations.
primary securities
Securities issued
by corporations
and backed by the
real assets of those
corporations.
The first function is the brokerage function. When acting as a pure broker, an FI acts
as an agent for the saver by providing information and transaction services. For
example, full-service securities firms (e.g., Bank of America Merrill Lynch) carry
out investment research and make investment recommendations for their retail
(or household) clients as well as conduct the purchase or sale of securities for
commission or fees. Discount brokers (e.g., Charles Schwab) carry out the purchase or sale of securities at better prices and with greater efficiency than household savers could achieve by trading on their own. This efficiency results in
reduced costs of trading, or economies of scale (see Chapter 21 for a detailed
discussion). Similarly, independent insurance brokers identify the best types of
insurance policies household savers can buy to fit their savings and retirement
plans. In fulfilling a brokerage function, the FI plays an extremely important role
by reducing transaction and information costs or imperfections between households and corporations. Thus, the FI encourages a higher rate of savings than
would otherwise exist.
FIs Function as Asset Transformers
The second function is the asset-transformation function. In acting as an asset
transformer, the FI issues financial claims that are far more attractive to household savers than the claims directly issued by corporations. That is, for many
households, the financial claims issued by FIs dominate those issued directly
by corporations as a result of lower monitoring costs, lower liquidity costs, and
lower price risk. In acting as asset transformers, FIs purchase the financial claims
issued by corporations—equities, bonds, and other debt claims called primary
securities—and finance these purchases by selling financial claims to household
FIGURE 1–2
Flow of Funds in a
World with FIs
FI
(brokers)
Households
Cash
Deposits and
insurance policies
FI
(asset
transformers)
Corporations
Equity
and debt
Cash
6
Part One
Introduction
secondary
securities
Securities issued by
FIs and backed by
primary securities.
investors and other sectors in the form of deposits, insurance policies, and so on.
The financial claims of FIs may be considered secondary securities because these
assets are backed by the primary securities issued by commercial corporations
that in turn invest in real assets. Specifically, FIs are independent market parties
that create financial products whose value added to their clients is the transformation of financial risk.
How can FIs purchase the direct or primary securities issued by corporations and profitably transform them into secondary securities more attractive to
household savers? This question strikes at the very heart of what makes FIs special and important to the economy. The answer lies in the ability of FIs to better
resolve the three costs facing a saver who chooses to invest directly in corporate
securities.
Information Costs
agency costs
Costs relating to the
risk that the owners
and managers of firms
that receive savers’
funds will take actions
with those funds
contrary to the best
interests of the savers.
One problem faced by an average saver directly investing in a commercial firm’s
financial claims is the high cost of information collection. Household savers must
monitor the actions of firms in a timely and complete fashion after purchasing
securities. Failure to monitor exposes investors to agency costs, that is, the risk
that the firm’s owners or managers will take actions with the saver’s money contrary to the promises contained in the covenants of its securities contracts. Monitoring costs are part of overall agency costs. That is, agency costs arise whenever
economic agents enter into contracts in a world of incomplete information and
thus costly information collection. The more difficult and costly it is to collect
information, the more likely it is that contracts will be broken. In this case the
saver (the so-called principal) could be harmed by the actions taken by the borrowing firm (the so-called agent).
FI’s Role as Delegated Monitor
delegated monitor
An economic agent
appointed to act on
behalf of smaller
agents in collecting
information and/or
investing funds on
their behalf.
One solution to this problem is for a large number of small savers to place their
funds with a single FI. This FI groups these funds together and invests in the direct
or primary financial claims issued by firms. This agglomeration of funds resolves
a number of problems. First, the large FI now has a much greater incentive to collect information and monitor actions of the firm because it has far more at stake
than does any small individual household. In a sense, small savers have appointed
the FI as a delegated monitor to act on their behalf. Not only does the FI have a
greater incentive to collect information, the average cost of collecting information
is lower. For example, the cost to a small investor of buying a $100 broker’s report
may seem inordinately high for a $10,000 investment. For an FI with $10 million
under management, however, the cost seems trivial. Such economies of scale of
information production and collection tend to enhance the advantages to savers of
using FIs rather than directly investing themselves.
FI’s Role as Information Producer
Second, associated with the greater incentive to monitor and the costs involved in
failing to monitor appropriately, FIs may develop new secondary securities that
enable them to monitor more effectively. Thus, a richer menu of contracts may
improve the monitoring abilities of FIs. Perhaps the classic example of this is the
bank loan. Bank loans are generally shorter-term debt contracts than bond contracts. This short-term nature allows the FI to exercise more monitoring power
and control over the borrower. In particular, the information the FI generates
Chapter 1
Why Are Financial Institutions Special?
7
regarding the firm is frequently updated as its loan renewal decisions are made.
When bank loan contracts are sufficiently short term, the banker becomes almost
like an insider to the firm regarding informational familiarity with its operations
and financial conditions. Indeed, this more frequent monitoring often replaces
the need for the relatively inflexible and hard-to-enforce covenants found in bond
contracts. Thus, by acting as a delegated monitor and producing better and more
timely information, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy.
Liquidity and Price Risk
diversify
Reducing risk by
holding a number of
different securities in
a portfolio.
In addition to improving the flow and quality of information, FIs provide financial or secondary claims to household and other savers. Often, these claims have
superior liquidity attributes compared with those of primary securities such as
corporate equity and bonds. For example, depository institutions issue transaction account deposit contracts with a fixed principal value (and often a guaranteed interest rate) that can be withdrawn immediately on demand by household
savers. Money market mutual funds issue shares to household savers that allow
those savers to enjoy almost fixed principal (depositlike) contracts while often
earning interest rates higher than those on bank deposits. Even life insurance companies allow policyholders to borrow against their policies held with the company
at very short notice. The real puzzle is how FIs such as depository institutions
can offer highly liquid and low price risk contracts to savers on the liability side
of their balance sheets while investing in relatively illiquid and higher price risk
securities issued by corporations on the asset side. Furthermore, how can FIs be
confident enough to guarantee that they can provide liquidity services to investors and savers when they themselves invest in risky asset portfolios? And why
should savers and investors believe FIs’ promises regarding the liquidity of their
investments?
The answers to these questions lie in the ability of FIs to diversify away some
but not all of their portfolio risks. The concept of diversification is familiar to all
students of finance. Basically, as long as the returns on different investments are
not perfectly positively correlated, by exploiting the benefits of size, FIs diversify
away significant amounts of portfolio risk—especially the risk specific to the individual firm issuing any given security. Indeed, research has shown that equal
investments in as few as 15 securities can bring significant diversification benefits
to FIs and portfolio managers. Further, as the number of securities in an FI’s asset
portfolio increases beyond 15 securities, portfolio risk falls, albeit at a diminishing rate. What is really going on here is that FIs exploit the law of large numbers
in their investments, achieving a significant amount of diversification, whereas
because of their small size, many household savers are constrained to holding
relatively undiversified portfolios. This risk diversification allows an FI to predict
more accurately its expected return on its asset portfolio. A domestically and globally diversified FI may be able to generate an almost risk-free return on its assets.
As a result, it can credibly fulfill its promise to households to supply highly liquid
claims with little price or capital value risk. A good example of this is the ability of
a bank to offer highly liquid demand deposits—with a fixed principal value—as
liabilities, while at the same time investing in risky loans as assets. As long as an
FI is sufficiently large to gain from diversification and monitoring, its financial
claims are likely to be viewed as liquid and attractive to small savers compared
with direct investments in the capital market.
8
Part One
Introduction
Other Special Services
The preceding discussion has concentrated on three general or special services
provided by FIs: reducing household savers’ monitoring costs, increasing their
liquidity, and reducing their price risk exposure. Next, we discuss two other special
services provided by FIs: reduced transaction costs and maturity intermediation.
Reduced Transaction Costs
Just as FIs provide potential economies of scale in information collection, they
also provide potential economies of scale in transaction costs. For example, since
May 1, 1975, fixed commissions for equity trades on the NYSE have been abolished. As a result, small retail buyers face higher commission charges or transaction costs than do large wholesale buyers. By grouping their assets in FIs
that purchase assets in bulk—such as in mutual funds and pension funds—
household savers can reduce the transaction costs of their asset purchases. In
addition, bid–ask (buy–sell) spreads are normally lower for assets bought and
sold in large quantities.
Maturity Intermediation
An additional dimension of FIs’ ability to reduce risk by diversification is that
they can better bear the risk of mismatching the maturities of their assets and liabilities than can small household savers. Thus, FIs offer maturity intermediation
services to the rest of the economy. Specifically, through maturity mismatching,
FIs can produce long-term contracts, such as long-term, fixed-rate mortgage loans
to households, while still raising funds with short-term liability contracts. Further, while such mismatches can subject an FI to interest rate risk (see Chapters 8
and 9), a large FI is better able to manage this risk through its superior access
to markets and instruments for hedging such as loan sales and securitization
(Chapters 25 and 26); futures (Chapter 22); swaps (Chapter 24); and options, caps,
floors, and collars (Chapter 23).
Concept
Questions
1. What are the three major risks to household savers from direct security purchases?
2. What are two major differences between brokers (such as security brokers) and
depository institutions (such as commercial banks)?
3. What are primary securities and secondary securities?
4. What is the link between asset diversification and the liquidity of deposit contracts?
OTHER ASPECTS OF SPECIALNESS
The theory of the flow of funds points to three principal reasons for believing
that FIs are special, along with two other associated reasons. In reality, academics,
policymakers, and regulators identify other areas of specialness relating to certain
specific functions of FIs or groups of FIs. We discuss these next.
The Transmission of Monetary Policy
The highly liquid nature of depository institution deposits has resulted in their
acceptance by the public as the most widely used medium of exchange in the economy. Indeed, at the core of the two most commonly used definitions of the money
Chapter 1
www.federalreserve.gov
Why Are Financial Institutions Special?
9
supply—M1 and M21—lie depository institutions’ deposit contracts. Because the
liabilities of depository institutions are a significant component of the money supply that impacts the rate of inflation, they play a key role in the transmission of
monetary policy from the central bank to the rest of the economy. That is, depository institutions are the conduit through which monetary policy actions impact
the rest of the financial sector and the economy in general. Indeed, a major reason
the United States and world governments bailed out many depository institutions
and increased the deposit insurance limit from $100,000 to $250,000 per person per
bank during the financial crisis was so that central banks could implement aggressive monetary policy actions to combat collapsing financial markets. Monetary
policy actions include open market operations (the purchase and sale of securities
in the U.S. Treasury securities market), setting the discount rate (the rate charged
on “lender of last resort” borrowing from the Federal Reserve), and setting reserve
requirements (the minimum amount of reserve assets depository institutions must
hold to back deposits held as liabilities on their balance sheets). Appendix 1B to
the chapter (located at the book’s website, www.mhhe.com/saunders8e) reviews
the tools used by the Federal Reserve to implement monetary policy.
Credit Allocation
A further reason FIs are often viewed as special is that they are the major and
sometimes the only source of financing for a particular sector of the economy
pre-identified as being in special need of financing. Policymakers in the United
States and a number of other countries, such as the United Kingdom, have identified residential real estate as needing special subsidies. This has enhanced the specialness of FIs that most commonly service the needs of that sector. In the United
States, savings associations and savings banks have traditionally served the credit
needs of the residential real estate sector. In a similar fashion, farming is an especially important area of the economy in terms of the overall social welfare of the
population. The U.S. government has even directly encouraged financial institutions to specialize in financing this area of activity through the creation of Federal
Farm Credit Banks.
Intergenerational Wealth Transfers or Time Intermediation
The ability of savers to transfer wealth across generations is also of great importance to the social well-being of a country. Because of this, life insurance and pension funds (see Chapter 6) are often especially encouraged, via special taxation
relief and other subsidy mechanisms, to service and accommodate those needs.
Payment Services
Depository institutions (see Chapter 2) are special in that the efficiency with which
they provide payment services directly benefits the economy. Two important payment services are check-clearing and wire transfer services. For example, on any
given day, trillions of dollars worth of payments are effected through Fedwire and
1
M1: ($2,418.6 billion outstanding in October 2012) consists of (1) currency outside the U.S. Treasury,
Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers;
(3) demand deposits at all commercial banks other than those owed to depository institutions, the U.S.
government, and foreign banks and official institutions, less cash items in the process of collection and
Federal Reserve float; and (4) other checkable deposits (OCDs). M2: ($10,221.0 billion outstanding in
October 2012) consists of M1 plus (1) savings and small time deposits (time deposits in amounts of less
than $100,000) and (2) other nondeposit obligations of depository institutions.
10
Part One
Introduction
CHIPS, the two large wholesale payment wire networks in the United States (see
Chapter 17). Any breakdowns in these systems probably would produce gridlock
in the payment system with resulting harmful effects to the economy.
Denomination Intermediation
Both money market and debt–equity mutual funds are special because they provide services relating to denomination intermediation (see Chapter 5). Because
they are sold in very large denominations, many assets are either out of reach of
individual savers or would result in savers’ holding highly undiversified asset
portfolios. For example, the minimum size of a negotiable certificate of deposit
(CD) is $100,000 and commercial paper (short-term corporate debt) is often sold
in minimum packages of $250,000 or more. Individually, a saver may be unable to
purchase such instruments. However, by buying shares in a money market mutual
fund along with other small investors, household savers overcome the constraints
to buying assets imposed by large minimum denomination sizes. Such indirect
access to these markets may allow small savers to generate higher returns on their
portfolios as well.
SPECIALNESS AND REGULATION
negative
externalities
Action by an economic agent imposing
costs on other economic agents.
In the preceding section, FIs were shown to be special because of the various services they provide to sectors of the economy. Failure to provide these services or
a breakdown in their efficient provision can be costly to both the ultimate sources
(households) and users (firms) of savings. The financial crisis of the late 2000s
is a prime example of how such a breakdown in the provision of financial services can cripple financial markets worldwide and bring the world economy into
a recession. The negative externalities2 affecting firms and households when
something goes wrong in the FI sector of the economy make a case for regulation.
That is, FIs are regulated to protect against a disruption in the provision of the
services discussed earlier and the costs this would impose on the economy and
society at large. For example, bank failures may destroy household savings and
at the same time restrict a firm’s access to credit. Insurance company failures may
leave households totally exposed in old age to catastrophic illnesses and sudden
drops in income on retirement. Further, individual FI failures may create doubts
in savers’ minds regarding the stability and solvency of FIs in general and cause
panics and even runs on sound institutions. Indeed, this possibility provided the
reasoning in 2009 for an increase in the deposit insurance cap to $250,000 per person per bank. At this time, the FDIC was more concerned about the possibility
of contagious runs as a few major depository institutions (DIs) (e.g., IndyMac,
Washington Mutual) failed or nearly failed. At this point, the FDIC wanted to
instill confidence in the banking system and made the change to avoid massive
depositor runs from many of the troubled (and even safer) DIs, more DI failures,
and an even larger collapse of the financial system.
2
A good example of a negative externality is the costs faced by small businesses in a one-bank town
if the local bank fails. These businesses could find it difficult to get financing elsewhere, and their
customers could be similarly disadvantaged. As a result, the failure of the bank may have a negative or
contagious effect on the economic prospects of the whole community, resulting in lower sales, production, and employment.
Chapter 1
net regulatory
burden
The difference
between the private
costs of regulations
and the private benefits for the producers
of financial services.
Why Are Financial Institutions Special?
11
Although regulation may be socially beneficial, it also imposes private costs,
or a regulatory burden, on individual FI owners and managers. For example, regulations prohibit commercial banks from making loans to individual borrowers
that exceed more than 10 percent of their equity capital even though the loans
may have a positive net present value to the bank. Consequently, regulation is an
attempt to enhance the social welfare benefits and mitigate the social costs of the
provision of FI services. The private costs of regulation relative to the private benefits, for the producers of financial services, is called the net regulatory burden.
Six types of regulation seek to enhance the net social welfare benefits of financial
intermediaries’ services: (1) safety and soundness regulation, (2) monetary policy
regulation, (3) credit allocation regulation, (4) consumer protection regulation,
(5) investor protection regulation, and (6) entry and chartering regulation. Regulations are imposed differentially on the various types of FIs. For example, depository institutions are the most heavily regulated of the FIs. Finance companies,
on the other hand, are subject to many fewer regulations. Regulation can also be
imposed at the federal or the state level and occasionally at the international level,
as in the case of bank capital requirements (see Chapter 20). Finally, because of the
historically segmented nature of the U.S. FI system, many regulations in that system are institution-specific, for example, consumer protection legislation imposed
on bank credit allocation to local communities. However, these institution-specific
regulations are increasingly being liberalized (see Chapter 21).
Safety and Soundness Regulation
To protect depositors and borrowers against the risk of FI failure due, for example,
to a lack of diversification in asset portfolios, regulators have developed layers
of protective mechanisms. These mechanisms are intended to ensure the safety
and soundness of the FI and thus to maintain the credibility of the FI in the eyes
of its borrowers and lenders. Indeed, even during the worst of the financial crisis deposit runs at banks, savings institutions, and credit unions did not occur.
This is because the safety and soundness regulations in place protected virtually
all depositors from losing their money. Thus, while depository institution failures
increased significantly during the crisis, depositors felt little need to run.
In the first layer of protection are requirements encouraging FIs to diversify their
assets. Thus, banks are required not to make loans exceeding more than 10 percent
of their own equity capital funds to any one company or borrower (see Chapter 10).
A bank that has 10 percent of its assets funded by its own capital funds (and therefore 90 percent by deposits) can lend no more than 1 percent of its assets to any one
party.
The second layer of protection concerns the minimum level of capital or equity
funds that the owners of an FI need to contribute to the funding of its operations (see Chapter 20). For example, bank and insurance regulators are concerned
with the minimum ratio of capital to (risk) assets. The higher the proportion of
capital contributed by owners, the greater the protection against insolvency risk
to outside liability claim holders such as depositors and insurance policyholders.
This is because losses on the asset portfolio due, for example, to the lack of diversification are legally borne by the equity holders first, and only after equity is
totally wiped out by outside liability holders. For example, in 2008 the near failure and subsequent purchase by J.P. Morgan Chase of Washington Mutual left
Washington Mutual shareholders with very little. Consequently, by varying the
required degree of equity capital, FI regulators can directly affect the degree of
12
Part One
Introduction
www.fdic.gov
www.sipc.org
risk exposure faced by nonequity claim holders in FIs. Indeed, part of the TARP
program of 2008–2009 (approved by the U.S. Congress in October 2008 as a first
response to the financial crisis) was the Capital Purchase Program (CPP). The
goal of the CPP was to encourage U.S. financial institutions to build capital to
increase the flow of financing to U.S. businesses and consumers and to support
the U.S. economy. Further, regulators acted quickly to ensure the largest DIs had
sufficient capital to withstand large losses during the financial crisis. In late
February 2009, the Obama administration announced that it would conduct a
“stress test” of the 19 largest U.S. DIs, which would measure the ability of these DIs
to withstand a protracted economic slump: unemployment rate above 10 percent
and home prices dropping another 25 percent. Results of the stress test showed
that 10 of the 19 DIs needed to raise a total of $74.6 billion in capital. Within a
month of the May 7, 2009, release of the results the DIs had raised $149.45 billion
of capital. (See Chapter 20 for more discussion on the role of capital in FIs.)
The third layer of protection is the provision of guaranty funds such as the
Deposit Insurance Fund (DIF) for depository institutions, the Security Inves
tors Protection Corporation (SIPC) for securities firms, and the state guaranty
funds established (with regulator encouragement) to meet insolvency losses to
small claim holders in the life and property–casualty insurance industries (see
Chapter 19). By protecting FI claim holders, when an FI fails and owners’ equity or
net worth is wiped out, these funds create a demand for regulation of the insured
institutions to protect the funds’ resources (see Chapter 19 for more discussion).
For example, the FDIC monitors and regulates participants in the DIF.
The fourth layer of regulation is monitoring and surveillance itself. Regulators
subject all FIs, whether banks, securities firms, or insurance companies, to varying degrees of monitoring and surveillance. This involves on-site examination as
well as an FI’s production of accounting statements and reports on a timely basis
for off-site evaluation. Just as savers appoint FIs as delegated monitors to evaluate the behavior and actions of ultimate borrowers, society appoints regulators
to monitor the behavior and performance of FIs. Many of the regulatory changes
proposed in reaction to the financial crisis included significant increases in the
monitoring and surveillance of any financial institution whose failure could have
serious systemic effects.
Finally, note that regulation is not without costs for those regulated. For example, society’s regulators may require FIs to have more equity capital than private
owners believe is in their own best interests. Similarly, producing the information
requested by regulators is costly for FIs because it involves the time of managers,
lawyers, and accountants. Again, the socially optimal amount of information may
differ from an FI’s privately optimal amount.3 As noted earlier, the differences
between the private benefits to an FI from being regulated—such as insurance
fund guarantees—and the private costs it faces from adhering to regulation—such
as examinations—is called the net regulatory burden. The higher the net regulatory
burden on FIs, the more inefficiently they produce any given set of financial services from a private (FI) owner’s perspective.
3
Also, a social cost rather than social benefit from regulation is the potential risk-increasing behavior
(often called moral hazard ) that results if deposit insurance and other guaranty funds provide coverage to
FIs and their liability holders at less than the actuarially fair price (see Chapter 19 for further discussion).
Chapter 1
Why Are Financial Institutions Special?
13
Monetary Policy Regulation
www.federalreserve.gov
outside money
The part of the money
supply directly produced by the government or central bank,
such as notes and
coin.
inside money
The part of the money
supply produced by
the private banking
system.
Another motivation for regulation concerns the special role banks play in the
transmission of monetary policy from the Federal Reserve (the central bank) to the
rest of the economy. The problem is that the central bank directly controls only
the quantity of notes and coin in the economy—called outside money—whereas
the bulk of the money supply consists of deposits—called inside money. In theory, a central bank can vary the quantity of cash or outside money and directly
affect a bank’s reserve position as well as the amount of loans and deposits it can
create without formally regulating the bank’s portfolio. In practice, regulators have
chosen to impose formal controls (these are described in Appendix 1B, located at
the book’s website, www.mhhe.com/saunders8e). In most countries, regulators
commonly impose a minimum level of required cash reserves to be held against
deposits (see Chapter 18). Some argue that imposing such reserve requirements
makes the control of the money supply and its transmission more predictable. Such
reserves also add to an FI’s net regulatory burden if they are more than the institution believes are necessary for its own liquidity purposes. In general, whether
banks or insurance companies, all FIs would choose to hold some cash reserves—
even non-interest-bearing—to meet the liquidity and transaction needs of their
customers directly. For well-managed FIs, however, this optimal level is normally
low, especially if the central bank (or other regulatory body) does not pay interest
or pays very little interest on required reserves. As a result, FIs often view required
reserves as similar to a tax and as a positive cost of undertaking intermediation.
Credit Allocation Regulation
Credit allocation regulation supports the FI’s lending to socially important sectors
such as housing and farming. These regulations may require an FI to hold a minimum amount of assets in one particular sector of the economy or to set maximum
interest rates, prices, or fees to subsidize certain sectors. Examples of asset restrictions include the qualified thrift lender (QTL) test, which requires thrifts
(i.e., savings institutions) to hold 65 percent of their assets in residential mortgagerelated assets to retain a thrift charter, and insurance regulations, such as those
in New York State that set maximums on the amount of foreign or international
assets in which insurance companies can invest. Examples of interest rate restrictions are the usury laws set in many states on the maximum rates that can be
charged on mortgages and/or consumer loans and regulations (now abolished)
such as the Federal Reserve’s Regulation Q maximums on time and savings
deposit interest rates.
Such price and quantity restrictions may have justification on social welfare
grounds—especially if society has a preference for strong (and subsidized) housing and farming sectors. However, they can also be harmful to FIs that have to
bear the private costs of meeting many of these regulations. To the extent that the
net private costs of such restrictions are positive, they add to the costs and reduce
the efficiency with which FIs undertake intermediation.
Consumer Protection Regulation
Congress passed the Community Reinvestment Act (CRA) and the Home Mortgage Disclosure Act (HMDA) to prevent discrimination in lending. For example,
since 1975, the HMDA has assisted the public in determining whether banks and
other mortgage-lending institutions are meeting the needs of their local communities. HMDA is especially concerned about discrimination on the basis of age, race,
14
Part One
Introduction
www.ffiec.gov
www.federalreserve.gov
www.fdic.gov
www.occ.treas.gov
sex, or income. Since 1990, depository institutions have reported to their chief
federal regulator on a standardized form the reasons credit was granted or denied.
To get some idea of the information production cost of regulatory compliance in
this area, consider that the Federal Financial Institutions Examination Council
(FFIEC) processed information on more than 14.7 million mortgage transactions
from more than 7,632 institutions in 2012. (The council is a federal supervisory
body comprising the members of the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency.)4
Many analysts believe that community and consumer protection laws are
imposing a considerable net regulatory burden on FIs without providing offsetting
social benefits that enhance equal access to mortgage and lending markets. However, as deregulation proceeds and the trend toward consolidation and universal banking (see Chapter 2) continues, it is likely that such laws will be extended
beyond banks to other financial service providers, such as insurance companies,
that are not currently subject to CRA community lending requirements. Indeed, a
new Consumer Financial Protection Bureau to protect consumers across the financial sector from unfair, deceptive, and abusive practices was a part of the Wall
Street Reform and Consumer Protection Act passed by the U.S. Congress in 2010.
Further, a new credit card reform bill, effective in 2010, put unprecedented restrictions on the actions that may be taken by all credit card issuers against credit card
holders. Included in the bill were limits on allowable interest rate increases during the first year, limits on fees and penalties credit card companies may charge,
protection against arbitrary interest rate increases, provisions giving credit card
holders sufficient time to pay their bills, and the abolition of universal default
(a practice in which credit card issuers would raise interest rates on customers’
accounts resulting from actions on other accounts, e.g., missing a payment on a
utility bill would result in an increase in a credit card rate).
Investor Protection Regulation
A considerable number of laws protect investors who use investment banks
directly to purchase securities and/or indirectly to access securities markets
through investing in mutual or pension funds. Various laws protect investors
against abuses such as insider trading, lack of disclosure, outright malfeasance,
and breach of fiduciary responsibilities (see Chapter 4). Important legislation
affecting investment banks and mutual funds includes the Securities Acts of 1933
and 1934, the Investment Company Act of 1940, and the Wall Street Reform and
Consumer Protection Act of 2010. As with consumer protection legislation, compliance with these acts can impose a net regulatory burden on FIs.
Entry Regulation
The entry and activities of FIs are also regulated (e.g., new bank chartering regulations). Increasing or decreasing the cost of entry into a financial sector affects the
profitability of firms already competing in that industry. Thus, industries heavily
protected against new entrants by high direct costs (e.g., through required equity
or capital contributions) and high indirect costs (e.g., by restricting individuals
4
The FFIEC also publishes aggregate statistics and analysis of CRA and HMDA data. The Federal Reserve
and other regulators also rate bank compliance. For example, in 2012 the FDIC judged 2.6 percent of the
banks examined to be outstanding in CRA compliance, 96.1 percent as satisfactory, and 1.3 percent as
needing to improve or as being in noncompliance.
Chapter 1
Why Are Financial Institutions Special?
15
who can establish FIs) of entry produce bigger profits for existing firms than those
in which entry is relatively easy (see Chapter 21). In addition, regulations (such as
the Financial Services Modernization Act of 1999) define the scope of permitted
activities under a given charter (see Chapter 21). The broader the set of financial service activities permitted under a given charter, the more valuable that
charter is likely to be. Thus, barriers to entry and regulations pertaining to the
scope of permitted activities affect the charter value of an FI and the size of its net
regulatory burden.
Concept
Questions
1. Why should more regulation be imposed on FIs than on other types of private
corporations?
2. Define the concept of net regulatory burden.
3. What six major types of regulation do FIs face?
THE CHANGING DYNAMICS OF SPECIALNESS
At any moment in time, each FI supplies a set of financial services (brokerage
related, asset transformation related, or both) and is subject to a given net regulatory burden. As the demands for the special features of financial services change
as a result of changing preferences, macroeconomic conditions, and technology,
one or more areas of the financial services industry become more or less profitable. Similarly, changing regulations can increase or decrease the net regulatory
burden faced in supplying financial services in any given area. These demand,
cost, and regulatory pressures are reflected in changing market shares in different
financial service areas as some contract and others expand. Clearly, an FI seeking
to survive and prosper must be flexible enough to move to growing financial service areas and away from those that are contracting. If regulatory activity restrictions inhibit or reduce the flexibility with which FIs can alter their product mix,
this will reduce their competitive ability and the efficiency with which financial
services are delivered. That is, activity barriers within the financial services industry may reduce the ability to diversify and potentially add to the net regulatory
burden faced by FIs.
Trends in the United States
In Table 1–2 we show the changing shares of total assets in the U.S. financial
services industry from 1860 to 2012. A number of important trends are evident:
most apparent is the decline in the total share of depository institutions since
the Second World War. Specifically, the share of commercial banks declined from
54.5 to 32.9 percent between 1948 and 2012, while the share of thrifts (savings
banks, savings associations, and credit unions) fell from 12.0 to 6.9 percent over
the same period. Thus, services provided by depository institutions (payment
services, transaction costs services, information cost) have become relatively less
significant as a portion of all services provided by FIs. Similarly, insurance companies also witnessed a secular decline in their share, from 26.0 to 14.6 percent.
The most dramatically increasing trend is the rising share of investment companies (mutual funds and money market mutual funds), increasing their share
from 0.3 to 19.8 percent between 1948 and 2012. Investment companies differ from
16
Part One
Introduction
TABLE 1–2
Percentage Shares of Assets of Financial Institutions in the United States, 1860–2012
Sources: Randall Kroszner, “The Evolution of Universal Banking and Its Regulation in Twentieth Century America,” chap. 3 in Anthony Saunders and Ingo Walter, eds., Universal Banking Financial
System Design Reconsidered (Burr Ridge, IL: Irwin, 1996); and Federal Reserve Board, “Flow of Fund Accounts,” various issues. www.federalreserve.gov
Commercial
banks
Thrift
institutions
Insurance
companies
Investment
companies
Pension
funds
Finance
companies
Securities
brokers and
dealers
Real estate
investment
trusts
Total (%)
Total
($ trillions)
1860
1900
1922
1929
1948
1960
1970
1980
2000
2005
2012
71.4%
62.9%
63.3%
53.7%
54.5%
40.8%
42.6%
40.7%
30.5%
29.3%
32.9%
17.8
18.2
13.9
14.0
12.0
21.0
23.0
25.0
10.1
10.2
6.9
10.7
13.8
16.7
18.6
26.0
24.2
19.0
16.2
15.6
15.0
14.6
—
—
0.0
2.4
0.3
0.7
0.7
2.0
15.8
13.7
19.8
—
0.0
0.0
0.7
3.8
7.7
8.0
9.5
8.8
6.2
7.6
—
0.0
0.0
2.0
2.7
5.2
5.7
6.2
6.9
7.3
4.8
0.0
3.8
5.3
8.1
0.7
0.4
0.7
0.3
12.1
17.3
12.1
—
100.0%
—
100.0%
—
100.0%
—
100.0%
—
100.0%
0.0
100.0%
0.3
100.0%
0.1
100.0%
0.2
100.0%
1.0
100.0%
1.3
100.0%
0.001
0.016
0.075
0.123
0.218
0.500
1.079
3.140
15.93
23.80
28.68
Chapter 1
Why Are Financial Institutions Special?
17
banks and insurance companies in that they give savers cheaper access to the
direct securities markets. They do so by exploiting the comparative advantages of
size and diversification, with the transformation of financial claims, such as maturity transformation, a lesser concern. Thus, open-ended mutual funds buy stocks
and bonds directly in financial markets and issue savers shares whose value is
linked in a direct pro rata fashion to the value of the mutual fund’s asset portfolio.
Similarly, money market mutual funds invest in short-term financial assets such
as commercial paper, CDs, and Treasury bills and issue shares linked directly to
the value of the underlying portfolio. To the extent that these funds efficiently
diversify, they also offer price risk protection and liquidity services.
The Rise of Financial Services Holding Companies
To the extent that the financial services market is efficient and these trends reflect
the forces of demand and supply, they indicate a trend: savers increasingly prefer
the denomination intermediation and information services provided by mutual
funds. These FIs provide investments that closely mimic diversified investments
in the direct securities markets over the transformed financial claims offered by
traditional FIs. This trend may also indicate that the net regulatory burden on traditional FIs—such as banks and insurance companies—is higher than that on investment companies. Indeed, traditional FIs are unable to produce their services as cost
efficiently as they could previously.
Recognizing this changing trend, the U.S. Congress passed the Financial Services Modernization (FSM) Act, which repealed the 1933 Glass-Steagall barriers
between commercial banking, insurance, and investment banking. The act, promoted as the biggest change in the regulation of financial institutions in 70 years,
allowed for the creation of “financial services holding companies” that could
engage in banking activities, insurance activities, and securities activities. Thus,
after 70 years of partial or complete separation between insurance, investment
banking, and commercial banking, the Financial Services Modernization Act of
1999 opened the door for the creation of full-service financial institutions in the
United States similar to those that existed before 1933 and that exist in many other
countries. As a result, while Table 1–2 lists assets of financial institutions by functional area, the financial services holding company (which combines these activities in a single financial institution) has become the dominant form of financial
institution in terms of total assets.
The Shift Away from Risk Measurement and Management
and the Financial Crisis
Certainly, a major event that changed and reshaped the financial services industry was the financial crisis of the late 2000s. As FIs adjusted to regulatory changes
brought about by the likes of the FSM Act, one result was a dramatic increase in
systemic risk of the financial system, caused in large part by a shift in the banking
model from that of “originate and hold” to “originate to distribute.” In the traditional model, banks take short term deposits and other sources of funds and use
them to fund longer term loans to businesses and consumers. Banks typically hold
these loans to maturity, and thus have an incentive to screen and monitor borrower
activities even after a loan is made. However, the traditional banking model exposes
the institution to potential liquidity, interest rate, and credit risk. In attempts to
avoid these risk exposures and generate improved return–risk trade-offs, banks
have shifted to an underwriting model in which they originate or warehouse loans,
18
Part One
Introduction
and then quickly sell them. Figure 1–3 shows the growth in bank loan secondary
market trading from 1991 through the third quarter of 2012. Note the huge growth
in bank loan trading even during the financial crisis of 2008–2009. When loans
trade, the secondary market produces information that can substitute for the information and monitoring of banks.5 Further, banks may have lower incentives to collect information and monitor borrowers if they sell loans rather than keep them
as part of the bank’s portfolio of assets. Indeed, most large banks are organized as
financial service holding companies to facilitate these new activities.
More recently, activities of shadow banks—nonfinancial service firms that perform banking services—have facilitated the change from the originate and hold
model of commercial banking to the originate and distribute banking model.
Participants in the shadow banking system include structured investment vehicles
(SIVs), special-purpose vehicles (SPVs), asset-backed paper vehicles, credit hedge
funds, asset-backed commercial paper (ABCP) conduits, limited-purpose finance
companies, money market mutual funds (MMMFs), and credit hedge funds (see
Chapter 21 for a detailed discussion of these FIs). In the shadow banking system,
savers place their funds with money market mutual6 and similar funds, which
invest these funds in the liabilities of other shadow banks. Borrowers get loans
and leases from shadow banks such as finance companies rather than from banks.
Like the traditional banking system, the shadow banking system intermediates
the flow of funds between net savers and net borrowers. However, instead of
the bank serving as the middleman, it is the nonbank financial service firm, or
shadow bank, that intermediates. Further, unlike the traditional banking system,
Trading Volume ($ billion)
600.0
500.0
400.0
300.0
200.0
2011
2012Q3
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
0.0
1993
100.0
1992
Bank Loan
Secondary
Market Trading,
1991–2012Q3
1991
FIGURE 1–3
5
A. Gande and A. Saunders, “Are Banks Still Special When There Is a Secondary Market for Loans?”
Journal of Finance, 2012, pp. 1649–1684, find that equity of borrowers whose bank loans trade on secondary markets for the first time receive positive announcement period returns. Further, announcements
by banks of new loans to a borrower after the borrower’s loans begin trading in the secondary markets
show positive announcement period returns.
6
Recent regulatory proposals recognize that MMMFs are operating as “banks.” These proposals include
requirements that MMMFs maintain capital levels similar to banks and/or that fund shares be backed by a
private deposit insurance scheme.
Chapter 1
Why Are Financial Institutions Special?
19
where the complete credit intermediation is performed by a single bank, in the
shadow banking system it is performed through a series of steps involving many
nonbank financial service firms.
These innovations remove risk from the balance sheet of financial institutions
and shift risk off the balance sheet to other parts of the financial system. Since the
FIs, acting as underwriters, are not exposed to the credit, liquidity, and interest
rate risks of traditional banking, they have little incentive to screen and monitor
activities of borrowers to whom they originate loans. Thus, FIs’ role as specialists
in risk measurement and management has been reduced.
Adding to FIs’ move away from risk measurement and management was the
boom (“bubble”) in the housing markets, which began building in 2001, particularly after the terrorist attacks of 9/11. The immediate response by regulators to
the terrorist attacks was to create stability in the financial markets by providing
liquidity to FIs. For example, the Federal Reserve lowered the short-term interest
rate that banks and other financial institutions pay in the federal funds market and
even made lender of last resort funds available to nonbank FIs such as investment
banks. Perhaps not surprisingly, low interest rates and the increased liquidity
provided by the central banks resulted in a rapid expansion in consumer, mortgage, and corporate debt financing. Demand for residential mortgages and credit
card debt rose dramatically. As the demand for mortgage debt grew, especially
among those who had previously been excluded from participating in the market
because of their poor credit ratings, FIs began lowering their credit quality cut-off
points. Moreover, to boost their earnings, in the market now popularly known as
the “subprime market,” banks and other mortgage-supplying institutions often
offered relatively low “teaser” rates on adjustable rate mortgages (ARMs), i.e.,
exceptionally low initial interest rates, but, if market rates rose in the future, substantial increases in rates could occur after the initial rate period expired two or
three years later. Under the traditional, originate and hold, banking model, banks
might have been reluctant to so aggressively pursue low credit quality borrowers
for fear that the loans would default. However, under the originate to distribute model of banking, asset securitization and loan syndication allowed banks to
retain little or no part of the loans, and hence the default risk on loans that they
originated. Thus, as long as the borrower did not default within the first months
after a loan’s issuance and the loans were sold or securitized without recourse
back to the bank, the issuing bank could ignore longer term credit risk concerns.
The result was a deterioration in credit quality, at the same time as there was a
dramatic increase in consumer and corporate leverage.
Eventually, in 2006, housing prices started to fall. At the same time, the Federal Reserve started to raise interest rates as it began to fear inflation. Since
many subprime mortgages originated in the 2001–2005 period had adjustable
rates, the cost of meeting mortgage commitments rose to unsustainable levels
for many low income households. The confluence of falling house prices, rising interest rates, and rising mortgage costs led to a wave of mortgage defaults
in the subprime market and foreclosures that only reinforced the downward
trend in house prices. The number of subprime mortgages that were more than
60 days behind on their payments was 17.1 percent in June 2007 and more than
20 percent in August 2007. As this happened, the poor quality of the collateral
and credit quality underlying subprime mortgage pools became apparent, with
default rates far exceeding those apparently anticipated by the rating agencies
in setting their initial subprime mortgage securitizations ratings. In 2007, the
20
Part One
Introduction
percentage of subprime mortgage-backed securities delinquent by 90 days or
more was 10.09 percent, substantially higher than the 5.37 percent rate in May
2005. The financial crisis began. Appendix 1A to the chapter (located at the
book’s website, www.mhhe.com/saunders8e) provides a detailed discussion of
the causes of, major events during, and regulatory and industry changes resulting from the financial crisis
The economy relies on financial institutions to act as specialists in risk measurement and management. The importance of this was demonstrated in the aftermath of the FIs’ failure to perform this critical function during the global financial
crisis. The result was a worldwide breakdown in credit markets, as well as an
enhanced level of equity market volatility. When FIs failed to perform their critical
risk measurement and management functions, the result was a crisis of confidence
that disrupted financial markets.
Global Trends
In addition to these domestic trends, U.S. FIs must now compete not only with
other domestic FIs but increasingly with foreign FIs that provide services (such
as payment services and denomination intermediation) comparable to those of
U.S. FIs. For example, Table 1–3 lists the 10 largest banks in the world, measured
by total assets as of October 2012. Notice that only 1 of the top 10 banks is a U.S.
bank. Table 1–4 lists foreign versus domestic bank offices’ assets held in the United
States from 1992 through 2012. Total foreign bank assets over this period increased
£ ¥
:$
TABLE 1–3
The 10 Largest
Banks in the World
(in millions of
dollars)
Source: The Banker, February
2012. www.thebanker.com
TABLE 1–4
Total Assets
Deutsche Bank (Germany)
Mitsubishi UFJ Financial Group (Japan)
Industrial & Commerce Bank of China (China)
HSBC Holdings (United Kingdom)
Barclays Bank (United Kingdom)
BNP Paribas (France)
Japan Post Bank (Japan)
J.P. Morgan Chase (United States)
Crédit Agricole Groupe (France)
Royal Bank of Scotland (United Kingdom)
$2,809.9
2,803.4
2,763.6
2,721.1
2,584.3
2,563.0
2,513.2
2,321.3
2,317.1
2,295.8
Domestic versus Foreign Bank Offices’ Assets Held in the United States (in billions of dollars)
Source: Federal Reserve Board, “Flow of Fund Accounts,” Statistical Releases, various dates. www.federalreserve.gov
Foreign Bank Financial
Assets
Domestic Bank Financial
Assets
1992
1997
1999
2002
2004
2008
2012
$ 510.9
$ 819.1
$ 763.5
$ 823.0
$ 664.1
$ 1,624.5
$ 1,976.7
3,824.4
4,858.5
5,664.4
6,979.1
8,371.8
11,639.0
11,747.6
Chapter 1
Why Are Financial Institutions Special?
21
from $510.9 billion in 1992 to $1,976.7 billion in 2012. This consistently represents
over 10 percent (and has been as high as 21.9 percent) of total assets held in the
United States.
Concept
Questions
Internet Exercise
Summary
1. Is the share of bank and thrift assets growing as a proportion of total FI assets in the
United States?
2. What are the fastest growing FIs in the United States?
3. What were the causes of the financial crisis?
4. Describe the global challenges facing U.S. FIs in the early 2000s.
Go to the website of the Board of Governors of the Federal Reserve, and find the latest information available for foreign bank offices’ assets and liabilities held in the United States using
the following steps. At www.federalreserve.gov, click on “Economic Research and Data.”
Click on “Flow of Funds Accounts of the United States.” Click on the most recent date. Click
on “Level Tables.” This will download a file to your computer that will contain the most
recent information in Tables L.110 and L.111.
This chapter described various factors and forces impacting financial institutions and the specialness of the services they provide. These forces have resulted
in FIs, which have historically relied on making profits by performing traditional
special functions (such as asset transformation and the provision of liquidity services), expanding into selling financial services that interface with direct security
market transactions, such as asset management, insurance, and underwriting services. This is not to say that specialized or niche FIs cannot survive but rather that
only the most efficient FIs will prosper as the competitive value of a specialized FI
charter declines.
The major theme of this book is the measurement and management of FI risks.
In particular, although we might categorize or group FIs and label them life insurance companies, banks, finance companies, and so on, in fact, they face risks that
are more common than different. Specifically, all the FIs described in this and the
next five chapters (1) hold some assets that are potentially subject to default or
credit risk and (2) tend to mismatch the maturities of their balance sheets to a
greater or lesser extent and are thus exposed to interest rate risk. Moreover, all
are exposed to some degree of saver withdrawal or liquidity risk depending on
the type of claims sold to liability holders. And most are exposed to some type
of underwriting risk, whether through the sale of securities or by issuing various
types of credit guarantees on or off the balance sheet. Finally, all are exposed to
operating cost risks because the production of financial services requires the use
of real resources and back-office support systems.
In Chapters 7 through 26 of this textbook, we investigate the ways managers of
FIs are measuring and managing this inventory of risks to produce the best returnrisk trade-off for shareholders in an increasingly competitive and contestable
market environment.
22
Part One
Introduction
www.mhhe.com/saunders8e
Questions
and Problems
1. What are five risks common to all financial institutions?
2. Explain how economic transactions between household savers of funds and
corporate users of funds would occur in a world without financial institutions.
3. Identify and explain three economic disincentives that would dampen the
flow of funds between household savers of funds and corporate users of
funds in an economic world without financial institutions.
4. Identify and explain the two functions FIs perform that would enable the
smooth flow of funds from household savers to corporate users.
5. In what sense are the financial claims of FIs considered secondary securities,
while the financial claims of commercial corporations are considered primary
securities? How does the transformation process, or intermediation, reduce the
risk, or economic disincentives, to savers?
6. Explain how financial institutions act as delegated monitors. What secondary
benefits often accrue to the entire financial system because of this monitoring
process?
7. What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?
8. What are agency costs? How do FIs solve the information and related agency
costs experienced when household savers invest directly in securities issued
by corporations?
9. How do large FIs solve the problem of high information collection costs for
lenders, borrowers, and financial markets?
10. How do FIs alleviate the problem of liquidity risk faced by investors who
wish to buy securities issued by corporations?
11. How do financial institutions help individual savers diversify their portfolio
risks? Which type of financial institution is best able to achieve this goal?
12. How can financial institutions invest in high-risk assets with funding provided by low-risk liabilities from savers?
13. How can individual savers use financial institutions to reduce the transaction
costs of investing in financial assets?
14. What is maturity intermediation? What are some of the ways the risks of
maturity intermediation are managed by financial institutions?
15. What are five areas of institution-specific FI specialness and which types of
institutions are most likely to be the service providers?
16. How do depository institutions such as commercial banks assist in the implementation and transmission of monetary policy?
17. What is meant by credit allocation regulation? What social benefit is this type
of regulation intended to provide?
18. Which intermediaries best fulfill the intergenerational wealth transfer function? What is this wealth transfer process?
19. What are two of the most important payment services provided by financial
institutions? To what extent do these services efficiently provide benefits to
the economy?
20. What is denomination intermediation? How do FIs assist in this process?
21. What is negative externality? In what ways do the existence of negative externalities justify the extra regulatory attention received by financial institutions?
22. If financial markets operated perfectly and costlessly, would there be a need
for financial institutions?
23. Why are FIs among the most regulated sectors in the world? When is the net
regulatory burden positive?
Chapter 1
Why Are Financial Institutions Special?
23
24. What forms of protection and regulation do the regulators of FIs impose to
ensure their safety and soundness?
25. In the transmission of monetary policy, what is the difference between inside
money and outside money? How does the Federal Reserve try to control the
amount of inside money? How can this regulatory position create a cost for
depository institutions?
26. What are some examples of credit allocation regulation? How can this attempt
to create social benefits create costs to a private institution?
27. What is the purpose of the Home Mortgage Disclosure Act? What are the
social benefits desired from the legislation? How does the implementation of
this legislation create a net regulatory burden on financial institutions?
28. What legislation has been passed specifically to protect investors who use
investment banks directly or indirectly to purchase securities? Give some
examples of the types of abuses for which protection is provided.
29. How do regulations regarding barriers to entry and the scope of permitted
activities affect the charter value of financial institutions?
30. What reasons have been given for the growth of investment companies at the
expense of “traditional” banks and insurance companies?
31. What events resulted in banks’ shift from the traditional banking model of
“originate and hold” to a model of “originate and distribute”?
32. How did the boom in the housing market in the early and mid-2000s exacerbate FIs’ transition away from their role as specialists in risk measurement
and management?
33. What are the tools used by the Federal Reserve to implement monetary
policy?
34. Suppose the Federal Reserve instructs the Trading Desk to purchase $1 billion
of securities. Show the result of this transaction on the balance sheets of the
Federal Reserve System and commercial banks.
35. Explain how a decrease in the discount rate affects credit availability and the
money supply.
36. What changes did the Fed implement to its discount window lending policy
in the early 2000s?
37. Bank Three currently has $600 million in transaction deposits on its balance
sheet. The Federal Reserve has currently set the reserve requirement at 10 percent
of transaction deposits.
a. Suppose the Federal Reserve decreases the reserve requirement to 8 percent.
Show the balance sheet of Bank Three and the Federal Reserve System just
before and after the full effect of the reserve requirement change. Assume
that Bank Three withdraws all excess reserves and gives out loans and that
borrowers eventually return all of these funds to Bank Three in the form of
transaction deposits.
b. Redo part (a) using a 12 percent reserve requirement.
38. Which of the monetary tools available to the Federal Reserve is most often
used? Why?
39. Describe how expansionary activities conducted by the Federal Reserve
impact credit availability, the money supply, interest rates, and security prices.
Do the same for contractionary activities.
www.mhhe.com/saunders8e
The following questions and problems are based on material in Appendix 1B to
the chapter.
24
Part One
Introduction
Web Questions
40. Go to the Federal Reserve Board’s website at www.federalreserve.gov. Find
the latest figures for M1 and M2 using the following steps. Click on “Economic Research and Data.” Click on “View All.” Click on “Money Stock Measures.” This downloads a file onto your computer that contains the relevant
data. By what percentage have these measures of the money supply grown
over the past year?
41. Go to the Federal Reserve Board’s website at www.federalreserve.gov. Find
the latest figures for financial assets outstanding at various types of financial
institutions using the following steps. Click on “Economic Research and Data.”
Click on “Flow of Funds Accounts of the United States.” Click on the most
recent date. Click on “Level tables.” This downloads a file onto your computer
that contains the relevant data. How has the percent of financial assets held by
commercial banks changed since that listed in Table 1–2 for 2012?
Appendix 1A: The Financial Crisis: The Failure of Financial
Services Institution Specialness
View Appendix 1A at the website for this textbook (www.mhhe.com/saunders8e).
Appendix 1B: Monetary Policy Tools
www.mhhe.com/saunders8e
View Appendix 1B at the website for this textbook (www.mhhe.com/saunders8e).
Chapter Two
See Appendices Online at www.mhhe.com/saunders8e
• Appendix 2A: Financial Statement Analysis Using a Return on Equity (ROE) Framework
• Appendix 2B: Commercial Banks’ Financial Statements and Analysis
• Appendix 2C: Depository Institutions and Their Regulators
• Appendix 2D: Technology in Commercial Banking
Financial Services:
Depository
Institutions
INTRODUCTION
A theme of this book is that the products sold and the risks faced by modern financial institutions are becoming increasingly similar, as are the techniques used to
measure and manage those risks. To illustrate this, Tables 2–1A and 2–1B contrast the products sold by the financial services industry in 1950 with those sold in
2013. In 1999, the U.S. Congress passed the Financial Services Modernization Act
(FSMA), which repealed regulations that set barriers between commercial banking, insurance, and investment banking. The bill, promoted as the biggest change
in the regulation of financial institutions in nearly 70 years, allowed for the creation
of “financial services holding companies” that could engage in banking activities,
TABLE 2–1A Products Sold by the U.S. Financial Services Industry, 1950
Function
Institution
Depository institutions
Insurance companies
Finance companies
Securities firms
Pension funds
Mutual funds
Payment Savings Fiduciary
Services Products Services Business Consumer
X
X
X
X
X
X
X
X
X
*
*
Insurance
and Risk
Management
Debt
Products
Underwriting
Issuance of
Lending
Equity
X
X
X
X
X
* Minor involvement.
25
26
Part One
Introduction
TABLE 2–1B Products Sold by the U.S. Financial Services Industry, 2013
Function
Institution
Lending
Payment Savings Fiduciary
Services Products Services Business Consumer
Depository institutions
Insurance companies
Finance companies
Securities firms
Pension funds
Mutual funds
†
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
Underwriting
Issuance of
Equity
Debt
X
X
X
X
†
†
X
X
Insurance
and Risk
Management
Products
X
X
X
X
X
Selective involvement via affiliates.
insurance activities, and securities activities. The bill also allowed large banks to
place certian activities, including some securities underwriting, in direct bank subsidiaries. Thus, after nearly 70 years of partial or complete separation between the
various functions performed by financial institutions, the FSMA opened the door
for the creation of full-service financial institutions in the United States. Legislation enacted as a result of the financial crisis, however, represents a partial reversal
of this trend. For example, the “Volcker rule” provision of the Wall Street Reform
and Consumer Protection Act prohibits bank holding companies from engaging
in proprietary trading and limits their investments in hedge funds, private equity,
and related vehicles. Despite these most recent changes, many FIs operate in more
than one of the industries discussed in the next five chapters.
Furthermore, during the financial crisis, several nondepository financial institutions (e.g., investment banks Goldman Sachs and Morgan Stanley and finance
company GMAC) requested and were allowed to convert to bank holding companies. The change was recognition that their models of finance and investing
had become too risky and the FIs needed the cushion of bank deposits that kept
some of the bigger commercial banks like J.P. Morgan Chase relatively safe during
the crisis. By becoming bank holding companies, the firms agreed to significantly
tighter regulations and much closer supervision by bank examiners from government agencies rather than only the Securities and Exchange Commission. The
new charters required the FIs to be subject to more disclosure, hold higher capital
reserves, and take less risk. However, the new banks would also have access to
the full array of the Federal Reserve lending facilities, something the failed investment bank Lehman Brothers did not have.
In this chapter we begin by describing three major FI groups—commercial banks,
savings institutions, and credit unions—which are also called depository institutions (DIs) because a significant proportion of their funding comes from customer
deposits. Historically, commercial banks have operated as more diversified institutions, having a large concentration of residential mortgage assets but holding commercial loans and consumer loans as well. Savings institutions have concentrated
primarily on residential mortgages. Finally, credit unions have historically focused
on consumer loans funded with member deposits. In Chapters 3 through 6 other
(nondepository) FIs will be described. We focus on four major characteristics of
each group: (1) size, structure, and composition of the industry group, (2) balance
sheets and recent trends, (3) regulation, and (4) industry performance.
Chapter 2
FIGURE 2–1
A Simple
Depository
Institution Balance
Sheet
TABLE 2–2
Largest Depository
Institutions, 2012
(Banks and Savings
Institutions Ranked
by Total Assets
on September 30,
2012, in billions of
dollars)
Source: Quarterly reports,
2012.
Financial Services: Depository Institutions
27
Depository Institutions
Assets
Liabilities and Equity
Loans
Deposits
Other assets Other liabilities
and equity
Company
1. J.P. Morgan Chase
2. Bank of America
3. Citigroup
4. Wells Fargo
5. U.S. Bancorp
6. PNC Financial Services Corp.
7. Bank of New York Mellon
8. State Street Corp.
9. TD Bank
10. HSBC North America
Banking Assets
Holding Company Assets
$1,812.8
1,445.1
1,347.8
1,180.2
342.8
291.8
259.1
197.0
195.9
194.0
$2,321.3
2,168.0
1,931.3
1,374.7
352.3
301.1
340.1
204.1
212.5
320.8
Figure 2–1 presents a very simplified product-based balance sheet for depository institutions. Notice that DIs offer products to their customers on both sides
of their balance sheets (loans on the asset side and deposits on the liability side).
This joint-product nature of the DI business creates special challenges for management as they deal with the many risks facing these institutions. These risks will be
discussed later, in Chapters 7 through 26.
Table 2–2 lists the largest U.S. depository institutions in 2012. The ranking is by
size of assets devoted to banking services. The table also lists the assets at the holding company level. Many of these large depository institutions (e.g., J.P. Morgan
Chase, Bank of America) operate in other financial service areas (e.g., investment
banking and security brokerage) as well. Thus, assets held at the holding company level can be much larger than just those devoted to banking services. Several
depository institutions manage assets of over $1 trillion which reflects the dramatic trend toward consolidation and mergers among financial service firms in the
1990s and 2000s. The largest bank is J.P. Morgan Chase, created from the merger
of J.P. Morgan, Chase Manhattan, Bank One, and Washington Mutual; the second
largest is Bank of America, created by the merger of NationsBank BankAmerica,
and FleetBoston; and the third largest is Citigroup, created from the merger of
Citicorp and Travelers Insurance.
COMMERCIAL BANKS
commercial bank
A bank that accepts
deposits and makes
consumer, commercial,
and real estate loans.
Commercial banks make up the largest group of depository institutions measured by asset size. They perform functions similar to those of savings institutions and credit unions. That is, they accept deposits (liabilities) and make loans
(assets). However, they differ in their composition of assets and liabilities, which
are much more varied. Commercial bank liabilities usually include several types
of nondeposit sources of funds, while their loans are broader in range, including
consumer, commercial, and real estate loans. Commercial banking activity is also
28
Part One
Introduction
FIGURE 2–2
Small Banks
Breakdown of Loan
Portfolios
Large Banks
C&I
14.30% Credit card
0.33%
Source: Federal Deposit
Insurance Corporation,
September 2012. www.fdic.gov
C&I
21.00%
Consumer
4.63%
Other
6.65%
Real estate
74.09%
Credit card
9.85%
Real estate
49.09%
Consumer
9.11%
Other
10.95%
Note: Small banks are defined as banks with assets less than $1 billion. Large banks are defined as banks with assets
of $1 billion or more.
regulated separately from the activities of savings institutions and credit unions.
Within the banking industry the structure and composition of assets and liabilities
also vary significantly across banks of different asset sizes. For example, as shown
in Figure 2–2, small banks make proportionately fewer commercial and industrial
(C&I) loans and more real estate loans than do big banks.
Size, Structure, and Composition of the Industry
In late 2012 the United States had 6,168 commercial banks. Even though this may
seem a large number, in fact, the number of banks has been shrinking. For example, in 1985 there were 14,416 banks, and in 1989 there were 12,744. Figure 2–3
illustrates the number of bank mergers, bank failures, and new charters for the
period 1980 through 2012. Notice that much of the change in the size, structure,
and composition of this industry is the result of mergers and acquisitions. It was
FIGURE 2–3 Structural Changes in the Number of Commercial Banks, 1980–2012
Source: Federal Deposit Insurance Corporation, Quarterly Banking Profile, various issues. www.fdic.gov
Number
600
Mergers
New charters
Failures
500
400
300
200
100
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Year
Chapter 2
Financial Services: Depository Institutions
TABLE 2–3
Number of
Subsidiaries of
Selected Financial
Services Holding
Companies
Source: D. Avraham,
P. Selvaggi, and J.I. Vickery,
“A Structural View of U.S.
Bank Holding Companies,”
FRBNY Economic Policy
Review, July 2012.
community banks
Banks that specialize
in retail or consumer
banking.
Holding
Company
Rank
1
2
3
4
5
7
10
20
30
40
50
29
Domestic
Name
Commercial
Bank
Other
Foreign
J.P. Morgan Chase
Bank of America
Citigroup
Wells Fargo
Goldman Sachs
Morgan Stanley
Bank of New York Mellon
Regions Financial
Comerica
First Horizon National
Webster Financial
4
5
2
5
1
1
3
1
2
1
1
2,936
1,541
935
1,270
1,444
1,593
211
35
72
35
21
451
473
708
91
1,670
1,289
146
4
2
1
0
not until the 1980s and 1990s that regulators (such as the Federal Reserve or state
banking authorities) allowed banks to merge with other banks across state lines
(interstate mergers), and it has only been since 1994 that Congress has passed legislation (the Riegle-Neal Act) easing branching by banks across state lines. Indeed,
the number of branches at U.S. banks has increased from 43,293 in 1985 to 83,209
in 2012. Table 2–3 reports the number of subsidiaries for some of the largest financial services holding companies. Many of the nonbank subsidiaries reported in
the table manage trusts and investment funds beyond the traditional banking
business.
Further, the industry has seen some of the largest mergers and acquisitions
ever, such as J.P. Morgan’s acquisition of Chase Manhattan (for $33.6 billion)
in September 2000, Bank of America’s acquisition of FleetBoston Financial
(for $49.3 billion) in October 2003, J.P. Morgan Chase’s acquisition of Bank
One (for $60.0 billion) in January 2004, and Bank of New York’s accuisition of
Mellon Financial (for $18.3 billion) in 2007. Thus, while back-office operations are
being consolidated, bank customers have an increase in the number of branch
locations available to them. Finally, it has only been since 1987 that banks have
possessed (limited) powers to underwrite corporate securities. Full authority to
enter the investment banking (and insurance) business was received only with
the passage of the Financial Services Modernization Act in 1999. Thus, commercial banks may now merge with investment banks (and insurance companies). In
subsequent chapters, we discuss the impact that changing regulations as well as
technological advances have had on the drop in the number of commercial banks
(e.g., technology changes [Chapter 17], regulatory changes [Chapter 21], and competition [Chapter 21]).
A comparison of asset concentration by bank size (see Table 2–4) indicates
that the consolidations in banking appear to have reduced the asset share of the
smallest banks (under $1 billion) from 36.6 percent in 1984 to 9.0 percent in 2012.
These smaller or community banks—under $1 billion in asset size—tend to specialize in retail or consumer banking, such as providing residential mortgages and
consumer loans and accessing the local deposit base. Clearly, this group of banks
is decreasing in both number and importance.
30
Part One
TABLE 2–4
Introduction
U.S. Bank Asset Concentration, 1984 versus 2012
Source: FDIC Quarterly Banking Profile, fourth quarter 1984 and third quarter 2012. www.fdic.gov
2012
Number
6,168
All FDIC-insured
commercial banks
1. Under $100 million
2. $100 million–
$1 billion
3. $1 billion–$10 billion
4. $10 billion or more
2,034
3,608
437
89
Percent
of Total
1984
Assets*
13,069.9
33.0%
58.5
118.0
1,059.2
7.1
1.4
1,133.6
10,759.1
Percent
of Total
0.9%
8.1
8.7
82.3
Percent
Number of Total
14,483
12,044
2,161
254
24
Assets*
$2,508.9
Percent
of Total
83.2%
14.9
404.2
513.9
16.1%
20.5
1.7
0.2
725.9
864.8
28.9
34.5
* In billions of dollars.
regional or
superregional banks
Banks that engage in
a complete array of
wholesale commercial
banking activities.
federal funds
market
An interbank market
for short-term
borrowing and lending of bank reserves.
money center banks
Banks that have a
heavy reliance on nondeposit or borrowed
sources of funds.
The relative asset share of the largest banks (more than $1 billion in assets),
on the other hand, increased from 63.4 percent in 1984 to 91.0 percent in 2012.
The majority of banks in the two largest size classes are often either regional or
superregional banks. They engage in a more complete array of wholesale commercial banking activities, encompassing consumer and residential lending
as well as commercial and industrial lending (C&I loans), both regionally and
nationally. In addition, the big banks access markets for purchased funds—such as
the interbank or federal funds market—to finance their lending and investment
activities. However, some of the very biggest banks often have the separate title
money center banks. Currently, five banking organizations constitute the money
center bank group: Bank of New York Mellon, Deutsche Bank (through its U.S.
acquisition of Bankers Trust), Citigroup, J.P. Morgan Chase, and HSBC Bank USA
(formerly Republic NY Corporation).1,2 This number has been declining because
of the megamergers, discussed earlier.
It is important to note that asset or lending size does not necessarily make a
bank a money center bank. Thus, Bank of America Corporation, with $1,445 billion in assets in 2012 (the second-largest U.S. bank organization), is not a money
center bank, while Bank of New York Mellon (with only $259 billion in assets) is.
What makes a bank a money center bank is partly location3 and partly its heavy
reliance on nondeposit or borrowed sources of funds. In fact, because of its extensive retail branch network,4 Bank of America tends to be a net supplier of funds
on the interbank market (federal funds market). By contrast, money center banks
have few retail branches and rely almost entirely on wholesale and borrowed
funds as sources of assets or liabilities. Money center banks are also major particitpants in foreign currency markets and are therefore subject to foreign exchange
risk (see Chapter 13).
1
Bankers Trust was purchased by Deutsche Bank (a German bank) in 1998. The Bankers Trust name, however, has been retained for U.S. operations. Republic NY Corporation was purchased by HSBC (a British
bank) in 1999. Republic NY Bank has been retained for U.S. operations under the name HSBC Bank USA.
2
These banking organizations are mostly holding companies that own and control the shares of a bank
or banks.
3
A money center bank normally is headquartered in New York or Chicago. These are the traditional
national and regional centers for correspondent banking services offered to smaller community banks.
4
In 2012 Bank of America had more than 5,700 branches nationwide.
Chapter 2
TABLE 2–5
ROA and ROE
of Banks by Size,
1990–2012
Source: Federal Deposit
Insurance Corporation,
Various dates. www.fdic.gov
Financial Services: Depository Institutions
31
Percentage Return on Assets (insured commercial banks by consolidated assets)
Year
All Banks
$0ⴚ$100
Million
1990
1995
2000
2001
2003
2006
2007
2008
2009
2010
2012
0.49%
1.17
1.19
1.16
1.40
1.33
0.95
0.16
0.09
0.66
1.02
0.79%
1.18
1.01
0.91
0.94
0.95
0.82
0.36
0.06
0.36
0.78
$100 Millionⴚ
$1 Billion
0.78%
1.25
1.28
1.20
1.27
1.24
1.06
0.38
⫺0.01
0.34
0.89
$1 Billionⴚ
$10 Billion
$10 Billionⴙ
0.76%
1.28
1.29
1.31
1.46
1.35
1.08
⫺0.10
⫺0.35
0.19
1.25
0.38%
1.10
1.16
1.13
1.42
1.35
0.92
0.16
0.15
0.75
1.01
Percentage Return on Equity (insured commercial banks by consolidated assets)
spread
The difference
between lending and
deposit rates.
Year
All Banks
$0ⴚ$100
Million
1990
1995
2000
2001
2003
2006
2007
2008
2009
2010
2012
7.64%
14.68
14.07
13.10
15.31
13.06
9.29
1.62
0.85
5.99
9.06
9.02%
11.37
9.09
8.07
8.19
7.38
6.00
2.76
0.46
3.06
6.69
$100 Millionⴚ
$1 Billion
9.95%
13.48
13.56
12.24
12.80
12.20
10.34
3.68
⫺0.15
3.35
8.36
$1 Billionⴚ
$10 Billion
$10 Billionⴙ
10.25%
15.04
14.57
13.77
14.00
12.65
9.47
⫺0.90
⫺3.16
1.67
10.66
6.68%
15.60
14.42
13.43
16.37
13.40
9.22
1.70
1.44
6.78
8.97
The bigger banks tend to fund themselves in national markets and lend to
larger corporations. This means that their spreads (i.e., the difference between
lending and deposit rates) in the past (the 1990s) often were narrower than those
of smaller regional banks, which were more sheltered from competition in highly
localized markets. As a result, the largest banks’ return on assets (ROA) was below
that of smaller banks (see Table 2–5). However, as the barriers to interstate competition and expansion in banking have fallen in recent years and as large banks
have focused more on off-balance-sheet activities to generate income (see below),
the largest banks’ ROAs as well as returns on equity (ROEs) have often outperformed those of the smallest banks, especially those with assets under $100 million (see Table 2–5). Appendix 2A (located at the book’s website, www.mhhe.com/
saunders8e) shows how a bank’s ROE can be decomposed to examine the different underlying sources of profitability. This decomposition of ROE is often
referred to as DuPont analysis. Appendix 2B (also located at the book’s website)
contains an overview of the evaluation of bank performance and risk exposure.
The U.S. banking system is unique in that it consists of not only very big banks
but also a large number of relatively small community banks. This unique banking structure is largely the result of a legal framework that until recently restricted
32
Part One
Introduction
banks’ abilities to diversify geographically. Over time, with regulatory change (see
below) and financial innovation, large banks have become complex organizations
engaged in a wide range of activities worldwide. These large banks provide a variety of services to their customers, but often rely on factual financial information,
computer models, and centralized decision making as the basis for conducting
business. Small banks focus more on relationship banking, often basing decisions
on personal knowledge of customers’ creditworthiness and an understanding
of business conditions in the communities they serve. As discussed above, with
increased merger activity over the last 30 years, the number of community banks
(while still large) has declined. Although community banks hold only a small
share of the nation’s banking assets, they provide important financial services
(such as small-business lending) for which there are few, if any, substitutes. Thus,
community banks will likely continue to play an important role in the banking
industry even as technology and market conditions change.
Balance Sheet and Recent Trends
Assets
Figure 2–4 shows the broad trends over the 1951–2012 period in the four principal
earning asset areas of commercial banks: business loans (or C&I loans), securities,
mortgages, and consumer loans. Although business loans were the major asset on
bank balance sheets between 1965 and 1987, there has been a drop in their importance (as a proportion of the balance sheet) since 1987. This drop has been mirrored by an offsetting rise in holdings of securities and mortgages. These trends
reflect a number of long-term and temporary influences. One important long-term
influence has been the growth of the commercial paper market, which has become
an alternative funding source for major corporations. Another has been the securitization of mortgages—the pooling and packaging of mortgage loans for sale in
the form of bonds (see Chapter 26). A more temporary influence was the so-called
FIGURE 2–4 Portfolio Shift: U.S. Commercial Banks’ Financial Assets
Source: Federal Deposit Insurance Corporation, Statistics on Depository Institutions. www.fdic.gov
Percent of total
50
Securities
40
30
Business loans
20
Mortgages
10
Consumer loans
0
1951
1955
1960
1965
1970
1975
1980
Year
1985
1990
1995
2000
2005
2010
Chapter 2
TABLE 2–6
Financial Services: Depository Institutions
33
Assets
Balance Sheet (All
U.S. Commercial
Banks) as of
September 30,
2012 (in billions of
dollars)
Loans and securities
Investment securities
U.S. government securities
Other
Total loans
Interbank loans
Loans excluding interbank
Commercial and industrial
Real estate
Individual
All other
Less: Reserve for loan losses
Total cash assets
Other assets
Total assets
Source: Federal Deposit
Insurance Corporation,
September 30, 2012.
www.fdic.gov
$10,653.2
$3,909.3
$1,705.6
2,203.7
6,743.9
104.6
6,639.3
$1,401.2
3,569.9
1,206.9
619.8
158.5
1,228.4
1,188.3
13,069.9
Liabilities
Total deposits
Deposits held in foreign offices
Deposits held in domestic offices
Transaction accounts
Nontransaction accounts
Borrowings
Other liabilities
Total liabilities
Total equity capital
$ 9,622.4
$1,443.9
8,178.5
$1,303.0
6,875.5
1,568.6
378.2
11,569.2
1,500.7
credit crunch and decline in the demand for business loans as a result of the economic downturn and recession in 1989–92 and 2001–02. Further, the financial crisis and the recession of 2007–09 resulted in a reduction in all areas of lending and
an increase in the banks’ holdings of less risky securities investments (e.g., Treasury securities, federal funds, and U.S. government agency securities).
Look at the detailed balance sheet for all U.S. commercial banks as of September
2012 (Table 2–6). Total loans amount to $6,743.9 billion, or 51.6 percent of total assets,
and fall into four broad classes: business or C&I ($1,401.2 billion); commercial and
residential real estate ($3,569.9 billion); individual, such as consumer loans for auto
purchases and credit card debt ($1,206.9 billion); and all other loans, such as less
developed country (LDC) loans ($619.8 billion). In the investment security portfolio
of $3,909.3 billion, or 29.9 percent of total assets, U.S. government securities, such
as Treasury bonds, constitute $1,705.6 billion, with other securities (in particular,
municipal securities and investment-grade corporate bonds) making up the rest.5
A major inference we can draw from this asset structure is that credit or default
risk exposure is a major risk faced by modern commercial bank managers (see
Chapters 10 and 11). Because commercial banks are highly leveraged and therefore
5
The footnotes to commercial bank balance sheets also distinguish between securities held by banks for
trading purposes, normally for less than one year, and those held for longer-term investment purposes. The
large money center banks are often active in the secondary market trading of government securities, reflecting their important role as primary dealers in government securities at the time of Treasury security auctions.
34
Part One
Introduction
hold little equity (see below) compared with total assets, even a relatively small
number of loan defaults can wipe out the equity of a bank, leaving it insolvent.6
Liabilities
transaction
accounts
The sum of noninterest-bearing
demand deposits
and interest-bearing
checking accounts.
NOW accounts
Interest-bearing
checking accounts.
money market
mutual funds
Specialized mutual
funds that offer
depositlike interest
bearing claims to
savers.
negotiable CDs
Fixed-maturity
interest-bearing
deposits with face
values over $100,000
that can be resold in
the secondary market.
Commercial banks have two major sources of funds other than the equity provided
by owners: deposits and borrowed or other liability funds. A major difference
between banks and other firms is banks’ high leverage. For example, banks had an
average ratio of equity to assets of 11.48 percent in 2012. This implies that 88.52 percent of their assets were funded by debt, either deposits or borrowed funds.
Note in Table 2–6, the aggregate balance sheet of U.S. banks, that deposits
amounted to $9,622.4 billion, or 73.6 percent of total liabilities and equity, and borrowings and other liabilities were $1,568.6 billion and $378.2 billion, respectively. Of
the total stock of deposits, transaction accounts constituted 13.5 percent, or $1,303.0
billion. Transaction accounts are checkable deposits that bear no interest (demand
deposits) or are interest bearing (most commonly called NOW accounts, or negotiable order of withdrawal accounts). Since their introduction in 1980, interest-bearing
checking accounts—especially NOW accounts—have dominated the transaction
accounts of banks. However, since limitations are imposed on the ability of corporations to hold such accounts and since there are minimum balance requirements
for NOW accounts, non-interest-bearing demand deposits are still held. The second
major segment of deposits is retail or household savings and time deposits (also
called certificates of deposits or CDs), normally individual account holdings of
less than $100,000. Important components of bank retail savings accounts are small
nontransaction accounts, which include passbook savings accounts and retail time
deposits. Small nontransaction accounts constitute 63.6 percent of total deposits, or
$6,123.0 billion. However, this disguises an important trend in the supply of these
deposits to banks. Specifically, retail savings and time deposits have been falling in
recent years, largely as a result of competition from money market mutual funds.
These funds pay a competitive rate of interest based on wholesale money market
rates by pooling and investing funds (see Chapter 5) while requiring relatively
small-denomination investments by mutual fund investors.
The third major source of deposit funds consists of large time deposits (over
$100,000), which amounted to $752.5 billion, or approximately 7.8 percent of the
stock of deposits, in September 2012. These are primarily negotiable CDs (deposit
claims with promised interest rates and fixed maturities of at least 14 days) that
can be resold to outside investors in an organized secondary market. As such,
they are usually distinguished from retail time deposits by their negotiability and
secondary market liquidity.
Nondeposit liabilities comprise borrowings and other liabilities that together
total 16.8 percent of all bank liabilities, or $1,946.8 billion. These categories
include a broad array of instruments, such as purchases of federal funds (bank
reserves) on the interbank market and repurchase agreements (temporary swaps
of securities for federal funds) at the short end of the maturity spectrum to the
issuance of notes and bonds at the longer end.7
6
Losses such as those due to defaults are charged off against the equity (stockholders’ stake) in a bank.
Additions to the reserve for loan and lease losses account (and, in turn, the expense account “provisions for
losses on loans and leases”) to meet expected defaults reduce retained earnings and, thus, reduce equity of
the bank. Unexpected defaults (e.g., due to a sudden major recession) are meant to be written off against
the remainder of the bank’s equity (e.g., its retained earnings and funds raised from share offerings).
7
These instruments are explained in greater detail in later chapters, especially Chapter 18.
Chapter 2
Financial Services: Depository Institutions
35
Overall, the liability structure of bank balance sheets tends to reflect a shorter
maturity structure than does the asset portfolio with relatively more liquid instruments, such as deposits and interbank borrowings, used to fund less liquid assets
such as loans. Thus, maturity mismatch or interest rate risk and liquidity risk are
key exposure concerns for bank managers (see Chapters 8, 9, 12, and 18).
Equity
Commercial bank equity capital (11.48 percent of total liabilities and equity in
2012) consists mainly of common and preferred stock (listed at par value), surplus or additional paid-in capital, and retained earnings. Regulators require
banks to hold a minimum level of equity capital to act as a buffer against losses
from their on- and off-balance-sheet activities (see Chapter 20). Because of the
relatively low cost of deposit funding, banks tend to hold equity close to the minimum levels set by regulators. As we discuss in subsequent chapters, this impacts
banks’ exposures to risk and their ability to grow—both on and off the balance
sheet—over time.
Part of the TARP program of 2008–2009 was the Capital Purchase Program
intended to encourage U.S. financial institutions to build capital to increase the
flow of financing to U.S. businesses and consumers and to support the U.S.
economy. Under the program, the Treasury purchased more than $200 billion of
senior preferred equity. The senior preferred shares rank senior to common stock
should the bank be closed. In addition to capital injections received as part of the
Capital Purchase Program, TARP provided additional emergency funding to Citigroup ($25 billion) and Bank of America ($20 billion). Through 2012, $245 billion
of TARP capital injections had been allocated to DIs, of which $233.7 billion has
been paid back plus a return of $33.9 billion in dividends and assessments to the
government.
As part of the 2010 Wall Street Reform and Consumer Protection Act, the largest banks are subject to annual stress tests, designed to ensure that the banks are
properly capitalized. Scenarios used as part of the stress tests range from mild to
calamitous, with the most extreme including a 5 percent decline in gross domestic
product, an unemployment rate of 12 percent, and a volatile stock market that
loses half its value. The original stress test was announced in late February 2009
when the Obama administration announced that it would conduct a “stress test”
of the 19 largest U.S. DIs, which would measure the ability of these DIs to withstand a protracted economic slump: unemployment rate above 10 percent and
home prices dropping another 25 percent. Results of this first stress test showed
that 10 of the 19 DIs needed to raise a total of $74.6 billion in capital. Within a
month of the May 7, 2009, release of the results, the DIs had raised $149.45 billion
of capital. As part of the 2013 stress tests, the worst-case scenario includes international events, i.e., the eurozone plunges into recession and a sharp slowdown in
China spills into neighboring countries.
Internet Exercise
Go to the Federal Deposit Insurance Corporation website (www.fdic.gov) and find the latest
balance sheet information available for commercial banks using the following steps. Click on
“Analysts.” Click on “Statistics on Banking.” Click on “Run Report.” This will download a
file onto your computer that will contain the most recent balance sheet information for commercial banks.
36
Part One
Introduction
Off-Balance-Sheet Activities
off-balance-sheet
asset
An item that moves
onto the asset side
of the balance sheet
when a contingent
event occurs.
off-balance-sheet
liability
An item that moves
onto the liability side
of the balance sheet
when a contingent
event occurs.
The balance sheet itself does not reflect the total scope of bank activities. Banks
conduct many fee-related activities off the balance sheet. Off-balance-sheet (OBS)
activities are important, in terms of their dollar value and the income they generate
for banks—especially as the ability of banks to attract high-quality loan applicants
and deposits becomes ever more difficult. OBS activities include issuing various
types of guarantees (such as letters of credit), which often have a strong insurance
underwriting element, and making future commitments to lend. Both services
generate additional fee income for banks. Off-balance-sheet activities also involve
engaging in derivative transactions—futures, forwards, options, and swaps.
Under current accounting standards, such activities are not shown on the current balance sheet. Rather, an item or activity is an off-balance-sheet asset if,
when a contingent event occurs, the item or activity moves onto the asset side
of the balance sheet or an income item is realized on the income statement. Conversely, an item or activity is an off-balance-sheet liability if, when a contingent
event occurs, the item or activity moves onto the liability side of the balance sheet
or an expense item is realized on the income statement.
By moving activities off the balance sheet, banks hope to earn additional fee
income to complement declining margins or spreads on their traditional lending
business. At the same time, they can avoid regulatory costs or “taxes” since reserve
requirements and deposit insurance premiums are not levied on off-balance-sheet
activities (see Chapter 16). Thus, banks have both earnings and regulatory “taxavoidance” incentives to undertake activities off their balance sheets.
Off-balance-sheet activities, however, can involve risks that add to the overall
insolvency exposure of an FI. Indeed, at the very heart of the financial crisis were
losses associated with off-balance-sheet mortgage-backed securities created and
held by FIs. Losses resulted in the failure, acquisition, or bailout of some of the
largest FIs and a near meltdown of the world’s financial and economic systems.
However, off-balance-sheet activities and instruments have both risk-reducing as
well as risk-increasing attributes, and, when used appropriately, they can reduce
or hedge an FI’s interest rate, credit, and foreign exchange risks.
We show the notional, or face, value of bank OBS activities, and their distribution and growth, for 1992 to 2012 in Table 2–7. Notice the relative growth in
the notional dollar value of OBS activities in Table 2–7. By September 2012, the
notional value of OBS bank activities was $236,945.3 billion compared with
the $13,069.9 billion value of on-balance-sheet activities. It should be noted
that the notional, or face, value of OBS activities does not accurately reflect the
risk to the bank undertaking such activities. The potential for the bank to gain
or lose is based on the possible change in the market value over the life of the
contract rather than the notional, or face, value of the contract, normally less than
3 percent of the notional value of an OBS contract.8
The use of derivative contracts (futures and forwards, swaps, and options)
accelerated during the 1992–2012 period and accounted for much of the growth in
OBS activity. Along with the growth in the notional value of OBS activities, banks
have seen significant growth in the percentage of their total operating income
8
For example, the market value of a swap (today) is the difference between the present value of the cash
flows (expected) to be received minus the present value of cash flows expected to be paid (see Chapter 24).
Chapter 2
Financial Services: Depository Institutions
37
TABLE 2–7
Aggregate Volume of Off-Balance-Sheet Commitments and Contingencies by U.S. Commercial
Banks, (in billions of dollars)
Sources: FDIC, Statistics on Banking, various issues. www.fdic.gov
1992
Commitments to lend
Future and forward contracts
(exclude FX)
On commodities and equities
On interest rates
Notional amount of credit derivatives
Standby contracts and other
option contracts
Option contracts on interest rates
Option contracts on foreign
exchange
Option contracts on commodities
Commitments to buy FX
(includes $US), spot, and forward
Standby LCs and foreign
office guarantees
(amount of these items sold to
others via participations)
Commercial LCs
Participations in acceptances
Securities borrowed or lent
Other significant commitments
and contingencies
Notional value of all outstanding swaps
Total
Total assets (on-balance-sheet items)
2003
2007
$
7,263.9
2009
$
5,406.3
2012*
$
5,234.6
Distribution
2012
$ 1,272.0
$ 5,398.9
2.2%
26.3
1,738.1
9.6
104.9
7,209.8
1,001.2
251.2
9,116.9
15,862.8
186.2
20,995.8
14,112.3
345.2
30,634.9
13,997.6
0.2
12.9
5.9
1,012.7
12,539.5
20,984.4
27,166.2
26,332.8
11.1
494.8
60.3
1,298.3
767.5
4,024.7
2,715.9
2,714.0
2,001.5
4,480.8
2,539.5
1.9
1.1
3,015.5
4,351.1
10,057.9
9,212.5
15,321.4
6.5
162.5
348.9
1,139.6
1,098.5
1,257.5
0.5
(14.9)
28.1
1.0
107.2
(60.3)
24.2
0.5
852.0
(220.5)
29.7
0.1
2,052.2
(192.1)
22.5
0.0
1,027.3
(302.0)
24.2
0.0
996.7
0.0
0.0
0.4
8.7
2,122.0
$10,075.8
$ 3,476.4
53.3
44,082.7
$78,032.8
$ 7,602.5
173.1
103,091.1
$176,763.5
$ 11,176.1
151.7
139,126.6
$223,221.4
$ 11,822.7
224.3
135,555.8
$236,945.3
$ 13,069.9
0.1
57.2
100.0%
FX ⫽ foreign exchange; LC ⫽ letter of credit.
* As of September.
(interest income plus noninterest income) coming from these non-balance-sheet
activities. Indeed, the percentage of noninterest income to total operating income
has increased from 22.66 percent in 1979 to 33.73 percent in 2012. As we discuss
in detail in Chapters 22 through 24, the significant growth in derivative securities
activities by commercial banks has been a direct response to the increased interest
rate risk, credit risk, and foreign exchange risk exposures they have faced, both
domestically and internationally. In particular, these contracts offer banks a way
to hedge these risks without having to make extensive changes on the balance
sheet. However, these assets and liabilities also introduce unique risks that must
be managed. The failure or near failure of some of the largest U.S. financial institutions during the financial crisis can be attributed to risks associated with OBS
activities (e.g., Citigroup). As mortgage borrowers defaulted on their mortgages,
financial institutions that held these “toxic” mortgages and “toxic” credit derivatives (in the form of mortgage backed securities) started announcing huge losses
on them. Losses from the falling value of OBS securities reached over $1 trillion
worldwide through 2009.
38
Part One
Introduction
The TARP gave the U.S. Treasury funds to buy “toxic” mortgages and other
securities from financial institutions. However, the TARP plan was slow to be
instituted and not all FIs chose to participate in the program. Better capitalized
FIs wanted to hold on to their troubled OBS securities rather than sell them and
record losses. Then early 2009 saw a plunge in the market values of financial institutions. Banks such as Citigroup, Bank of America, and J.P. Morgan Chase traded
at less than their book value as investors had little confidence in the value of their
assets. As a result, a new plan, announced on February 10, 2009, involved a number of initiatives, including offering federal insurance to banks against losses on
bad assets and expanding the Fed’s Term Asset-Backed Securities Loan Facility
(TALF). Further, the Treasury, working with the Federal Reserve, FDIC, and private investors, created the Public–Private Investment Fund (PPIF) to acquire realestate related OBS assets. By selling to PPIF, financial institutions could reduce
balance sheet risk, support new lending, and help improve overall market functioning. The PPIF facility was initially funded at $500 billion with plans to expand
the program to up to $1.25 trillion over time. After several months of discussion,
in July 2009, the government had selected nine financial firms to manage a scaleddown program; investing $30 billion to start the fund. The selected firms had
12 weeks to raise $500 million of capital each from private investors willing to
invest in FI’s toxic assets. The total investment would be matched by the federal
government. The purchases of $1.25 trillion in OBS mortgage-backed securities
were completed in March 2010.
Although the simple notional dollar value of OBS items overestimates their
risk exposure amounts, the increase in these activities is still nothing short of
phenomenal. Indeed, this phenomenal increase pushed regulators into imposing capital requirements on such activities and explicitly recognizing an FI’s
solvency risk exposure from pursuing such activities. We describe these capital
requirements in Chapter 20. Further, as a result of the role derivatives played in
the financial crisis, in spring 2009, regulators proposed a revamping of the U.S.
financial regulatory system that included extending regulatory oversight to
unregulated OTC derivative securities (see below). The regulation requires that all
over-the-counter derivative contracts be subject to regulation, all derivatives dealers subject to supervision, and regulators be empowered to enforce rules against
manipulation and abuse.
Other Fee-Generating Activities
Commercial banks engage in other fee-generating activities that cannot easily be
identified from analyzing their on- and off-balance-sheet accounts. Two of these
are trust services and correspondent banking.
Trust Services
The trust department of a commercial bank holds and manages assets for individuals or corporations. Only the largest banks have sufficient staff to offer trust
services. Individual trusts represent about one-half of all trust assets managed by
commercial banks. These trusts include estate assets and assets delegated to bank
trust departments by less financially sophisticated investors. Pension fund assets
are the second largest group of assets managed by the trust departments of commercial banks. The banks manage the pension funds, act as trustees for any bonds
held by the pension funds, and act as transfer and disbursement agents for the
pension funds.
Chapter 2
Financial Services: Depository Institutions
39
Correspondent Banking
Correspondent banking is the provision of banking services to other banks that
do not have the staff resources to perform the service themselves. These services
include check clearing and collection, foreign exchange trading, hedging services,
and participation in large loan and security issuances. Correspondent banking
services are generally sold as a package of services. Payment for the services is
generally in the form of non-interest-bearing deposits held at the bank offering the
correspondent services (see Chapter 16).
Regulation
The Regulators
www.fdic.gov
Unlike banks in countries that have one or sometimes two regulators, U.S. banks
may be subject to the supervision and regulations of up to four separate regulators. The key regulators are the Federal Deposit Insurance Corporation (FDIC),
the Office of the Comptroller of the Currency (OCC), the Federal Reserve System (FRS), and state bank regulators. Next, we look at the principal roles played
by each regulator. Appendix 2C (located at the book’s website, www.mhhe.com/
saunders8e) lists in greater detail the regulators that oversee the various activities
of depository institutions.
The FDIC Because of the serious social welfare effects that a contagious run
on depository institutions could have, the Federal Deposit Insurance Corporation (FDIC) has established guarantee programs offering deposit holders varying degrees of insurance protection to deter depositor “runs.” While a run on an
unhealthy DI is not necessarily a bad thing, there is a risk that runs on bad DIs
can become contagious and spread to good or well-run DIs. In a contagious run
or panic conditions, liability holders do not bother to distinguish between good
and bad DIs but, instead, seek to turn their liabilities into cash or safe securities
as quickly as possible. Contagious runs can have a major contractionary effect on
the supply of credit as well as the money supply regionally, nationally, or even
internationally. Moreover, a contagious run on DIs can have serious social welfare
effects. For example, a major run on banks can have an adverse effect on the level
of savings in all types of FIs and therefore can inhibit the ability of individuals
to transfer wealth through time to protect themselves against major risks such
as future ill health and falling income in old age. However, if a deposit holder
believes a claim is totally secure, even if the DI is in trouble, the holder has no
incentive to run. Thus, FDIC deposit insurance deters runs as well as contagious
runs and panics.
To see how deposit insurance protects commercial banks from depositor runs,
consider the case of Bear Stearns, an investment bank. In the summer of 2007,
two Bear Stearns hedge funds suffered heavy losses on investments in the subprime mortgage market. The two funds filed for bankruptcy in the fall of 2007.
Bear Stearns’ market value was hurt badly from these losses. The losses became
so great that by March 2008 Bear Stearns was struggling to finance its day-to-day
operations. Lacking of any kind of federal insurance of its liabilities, rumors of
Bear Stearns’ liquidity crisis became a reality as investors began quickly selling
their stock and draining what little liquid assets the firm had left; the first major
run on a U.S. FI since the Great Depression. In contrast, during the financial crisis investors, looking for a “safer haven” for their money, deposited funds in
FDIC-insured depository institutions.
40
Part One
Introduction
www.occ.treas.gov
dual banking
system
The coexistence
of both nationally
chartered and state
chartered banks in the
United States.
www.federalreserve.gov
In exchange for insuring the deposits of member banks, the Federal Deposit
Insurance Corporation levies insurance premiums on member banks, manages
the deposit insurance fund, and carries out bank examinations. Further, when an
insured bank is closed, the FDIC acts as the receiver and liquidator—although the
closure decision itself is technically in the hands of the bank chartering or licensing agency, such as the OCC. Because of the problems in the thrift industry and
the insolvency of the savings association insurance fund (FSLIC) in 1989, the FDIC
managed both the commercial bank insurance fund and the savings association
insurance fund. In 2007, the two funds were combined into one, the Deposit Insurance Fund (DIF). The number of FDIC-insured banks and the division between
nationally chartered and state chartered banks is shown in Figure 2–5.
Office of the Comptroller of the Currency (OCC) The OCC is the oldest bank
regulatory agency. Established in 1863, it is a subagency of the U.S. Treasury. Its
primary function is to charter so-called national banks as well as to close them. In
addition, the OCC examines national banks and has the power to approve or disapprove their merger applications. However, instead of seeking a national charter,
banks can be chartered by any of 50 individual state bank regulatory agencies. The
choice of being a nationally chartered or state chartered bank lies at the foundation of the dual banking system in the United States. While most large banks,
such as Bank of America, choose national charters, this is not always the case.
For example, Morgan Guaranty, the money center bank subsidiary of J.P. Morgan
Chase, is chartered as a state bank under New York state law. In September 2012,
1,273 banks were nationally chartered and 4,895 were state chartered, with approximately 69 percent and 31 percent of total commercial bank assets, respectively.
Federal Reserve System Apart from being concerned with the conduct of monetary policy, as this country’s central bank, the Federal Reserve also has regulatory
power over some banks and, when relevant, their holding company parents. All
of the 1,273 nationally chartered banks in Figure 2–5 are automatically members of
FIGURE 2–5
Insured Commercial Banks (FDIC-DIF) 2012
Bank Regulators
$13,069.9 billion in assets
Source: FDIC (internal
figures), September 2012.
www.fdic.gov
6,168 in number
1,273
4,895
Nationally
chartered
(OCC)
State-chartered
833
4,062
Members
(FRS)
Nonmembers
(FDIC)
Chapter 2
holding companies
Parent companies
that own a controlling
interest in subsidiary
banks or other FIs.
Financial Services: Depository Institutions
41
the Federal Reserve system; 833 state-chartered banks also have chosen to become
members. Since 1980, all banks have had to meet the same non-interest-bearing
reserve requirements whether they are members of the Federal Reserve System
(FRS) or not. The primary advantages of FRS membership are direct access to
the federal funds wire transfer network for nationwide interbank borrowing and
lending of reserves and to the discount window for lender of last resort borrowing
of funds. Finally, many banks are often owned and controlled by parent holding
companies. For example, Citigroup is the parent holding company of Citibank
(a bank). Because the holding company’s management can influence decisions
taken by a bank subsidiary and thus influence its risk exposure, the Federal
Reserve System regulates and examines bank holding companies as well as banks.
Regulations
Because of the inherent special nature of banking and banking contracts (see
Chapter 1), commercial banks are among the most regulated firms in the U.S.
economy. Regulators have imposed numerous restrictions on their product and
geographic activities. Table 2–8 lists the major laws from the McFadden Act of
1927 to the Wall Street Reform and Consumer Protection Act of 2010 and briefly
describes the key features of each act.
TABLE 2–8
Major Bank Laws,
Major Features
1927 The McFadden Act
1. Made branching of nationally chartered banks subject to the same branching regulations
as state-chartered banks.
2. Liberalized national banks’ securities underwriting activities, which previously had to be
conducted through state-chartered affiliates.
1933 The Banking Acts of 1933
1. The Glass-Steagall Act generally prohibited commercial banks from underwriting securities with four exceptions:
a. Municipal general obligation bonds.
b. U.S. government bonds.
c. Private placements.
d. Real estate loans.
2. In addition, the acts established the FDIC to insure bank deposits.
3. The Glass-Steagall Act prohibited banks from paying interest on demand deposits.
1956 The Bank Holding Company Act
1. Restricted the banking and nonbanking acquisition activities of multibank holding
companies.
2. Empowered the Federal Reserve to regulate multibank holding companies by:
a. Determining permissible activities.
b. Exercising supervisory authority.
c. Exercising chartering authority.
d. Conducting bank examinations.
1970 Amendments to the Bank Holding Company Act of 1956
1. Extended the BHC Act of 1956 to one-bank holding companies.
2. Restricted permissible BHC activities to those “closely related to banking.”
1978 International Banking Act
1. Regulated foreign bank branches and agencies in the United States.
2. Subjected foreign banks to the McFadden and Glass-Steagall Acts.
3. Gave foreign banks access to Fedwire, the discount window, and deposit insurance.
(continued)
42
Part One
TABLE 2–8
(continued)
Introduction
1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA)
1. Set a six-year phaseout for Regulation Q interest rate ceilings on small time and savings
deposits.
2. Authorized NOW accounts nationwide.
3. Introduced uniform reserve requirements for state-chartered and nationally chartered banks.
4. Increased the ceiling on deposit insurance coverage from $40,000 to $100,000.
5. Allowed federally chartered thrifts to make consumer and commercial loans (subject to
size restrictions).
1982 Garn–St. Germain Depository Institutions Act (DIA)
1. Introduced money market deposit accounts (MMDAs) and super NOW accounts as interest rate–bearing savings accounts with limited check-writing features.
2. Allowed federally chartered thrifts more extensive lending powers and demand deposit–
taking powers.
3. Allowed sound commercial banks to acquire failed savings institutions.
4. Reaffirmed limitations on bank powers to underwrite and distribute insurance.
1987 Competitive Equality in Banking Act (CEBA)
1. Redefined the definition of a bank to limit the growth of nonbank banks.
2. Sought to recapitalize the Federal Savings and Loan Insurance Corporation (FSLIC).
1989 Financial Institutions Reform Recovery and Enforcement Act (FIRREA)
1. Limited savings banks’ investments in nonresidential real estate, required divestiture of
junk bond holdings (by 1994), and imposed a restrictive asset test for qualifications as a
savings institution (the qualified thrift lender [QTL] test).
2. Equalized the capital requirements of thrifts and banks.
3. Replaced the FSLIC with the FDIC-SAIF.
4. Replaced the Federal Home Loan Bank Board as the charterer of federal savings and
loans with the Office of Thrift Supervision (OTS), an agency of the Treasury.
5. Created the Resolution Trust Corporation (RTC) to resolve failed and failing savings
institutions.
1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA)
1. Introduced prompt corrective action (PCA), requiring mandatory interventions by regulators whenever a bank’s capital falls.
2. Introduced risk-based deposit insurance premiums beginning in 1993.
3. Limited the use of too-big-to-fail bailouts by federal regulators for large banks.
4. Extended federal regulation over foreign bank branches and agencies in the Foreign
Bank Supervision and Enhancement Act (FBSEA).
1994 Riegle-Neal Interstate Banking and Branching Efficiency Act
1. Permitted bank holding companies to acquire banks in other states, starting September 1995.
2. Invalidated the laws of states that allowed interstate banking only on a regional or
reciprocal basis.
3. Beginning in June 1997, bank holding companies were permitted to convert out-of-state
subsidiary banks into branches of a single interstate bank.
4. Newly chartered branches also permitted interstate if allowed by state law.
1999 Financial Services Modernization Act
1. Eliminated restrictions on banks, insurance companies, and securities firms entering into each
others’ areas of business. Allowed for the creation of a financial services holding company.
2. Provided for state regulation of insurance.
3. Streamlined bank holding company supervision, with the Federal Reserve as the umbrella
holding company supervisor.
4. Prohibited FDIC assistance to affiliates and subsidiaries of banks and savings institutions.
5. Provided for national treatment of foreign banks engaging in activities authorized under
the act.
(continued)
Chapter 2
TABLE 2–8
(continued)
nonbank banks
Firms that undertake
many of the activities
of a commercial bank
without meeting the
legal definition of
a bank.
financial services
holding company
A financial institution that engages in
banking activities
and securities underwriting or any other
financial activity.
Financial Services: Depository Institutions
43
2010 Wall Street Reform and Consumer Protection Act
1. Created the Financial Services Oversight Council that would look out for systemic risks at
large FIs.
2. Gave the government power to break up FIs that provide a systemic risk to the financial
system.
3. Created the Consumer Financial Protection Bureau to regulate products such as credit
cards and mortgages.
4. Allowed Congress to order the Government Accountability Office to audit Federal
Reserve activities.
5. Gave shareholders the right to a nonbinding proxy vote on corporate pay packages.
6. Required some over-the-counter derivatives be traded through clearinghouses to provide
transparency of the value of trades.
Even though we will go into greater detail about these regulations in later
chapters (e.g., product and geographic diversification, Chapter 21), we now note
the major objectives of each of these laws. The 1927 McFadden Act sought to
restrict interstate bank branching, while the 1933 Glass-Steagall Act sought to separate commercial banking from investment banking by limiting the powers of
commercial banks to engage in securities activities. Restrictions on the nonbank
activities of commercial banks were strengthened by the Bank Holding Company
Act of 1956 and its 1970 amendments, which limited the ability of a bank’s parent
holding company to engage in commercial, insurance, and other nonbank financial service activities. The 1978 International Banking Act extended federal regulation, such as the McFadden and Glass-Steagall Acts, to foreign branches and
agencies in the United States for the first time, thereby seeking to level the competitive playing field between domestic and foreign banks. The 1980 DIDMCA
and the 1982 DIA are mainly deregulation acts in that they eliminated interest
ceilings on deposits and gave banks (and thrifts) new liability and asset powers.
As we discuss in the next section on thrifts, this deregulation is blamed in part
for the thrift crisis that resulted in widespread failures and the insolvency of the
FSLIC in 1989.
The Competitive Equality in Banking Act (CEBA) of 1987 sought to impose
controls over a growing number of nonbank banks that were established to
get around interstate banking restrictions and restrictions on nonbank ownership of banks imposed under the 1927 McFadden and the 1956 Bank Holding
Company Acts. In 1989 Congress responded to the problems of thrifts and the
collapse of the FSLIC with the passage of the FIRREA. In 1991 Congress enacted
the FDICIA to deal with a large number of bank failures and the threatened
insolvency of the FDIC, the insurance fund for commercial banks. Both the FIRREA and FDICIA sought to pull back from some of the deregulatory elements
of the 1980 DIDMCA and the 1982 DIA. In 1994 the Riegle-Neal Act rolled back
many of the restrictions on interstate banking imposed by the 1927 McFadden
and the 1956 Bank Holding Company Acts. In particular, since June 1997 bank
holding companies have been permitted to convert their bank subsidiaries in
various states into branches, thus making nationwide branching possible for the
first time in 70 years. In 1999 the Financial Services Modernization Act repealed
Glass-Steagall barriers between commercial banks and investment banks. The
act allowed for the creation of a financial services holding company that could
engage in banking activities and securities underwriting. In 2012, more than
750 banks qualified as financial services holding companies. This act also allows
44
Part One
Introduction
FI customers to opt out of any private information sharing an FI may want to
pursue. Thus, FI customers have some control over who will see and have access
to their private information.
Finally, in 2010, the U.S. Congress passed the 2010 Wall Street Reform and Consumer Protection Act which sought to prevent a repeat of the market meltdown
of 2008. Touted as the most extensive proposal for the overhaul of financial rules
since the Great Depression, this bill proposed a sweeping overhaul of the nation’s
financial system and the rules that govern it. The bill set forth reforms to meet five
key objectives:
1. Promote robust supervision and regulation of financial firms by establishing (a) a new
Financial Services Oversight Council of financial regulators (chaired by Treasury
and including the heads of the principal federal financial regulators as members) to identify emerging systemic risks and improve interagency cooperation,
(b) a new authority for the Federal Reserve to supervise all firms that could
pose a threat to financial stability, even those that do not own banks, (c) stronger
capital and other prudential standards for all financial firms, and even higher
standards for large, interconnected firms, (d) a new National Bank Supervisor to
supervise all federally chartered banks, (e) the elimination of the federal thrift
charter for thrifts not dedicated to mortgage lending and other loopholes that
allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve, and (f) the registration of advisers of hedge funds
and other private pools of capital with the SEC.
2. Establish comprehensive supervision of financial markets by establishing (a) the regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that
issuers and originators retain a financial interest in securitized loans, (b) comprehensive regulation of all over-the-counter derivatives, and (c) new authority
for the Federal Reserve to oversee payment, clearing, and settlement systems.
3. Protect consumers and investors from financial abuse by establishing (a) a new Consumer Financial Protection Bureau to protect consumers across the financial
sector from unfair, deceptive, and abusive practices, (b) stronger regulations
to improve the transparency, fairness, and appropriateness of consumer and
investor products and services, and (c) a level playing field and higher standards for providers of consumer financial products and services, whether or
not they are part of a bank.
4. Provide the government with the tools it needs to manage financial crises by establishing (a) a new regime to resolve nonbank financial institutions whose failure
could have serious systemic effects and (b) revisions to the Federal Reserve’s
emergency lending authority to improve accountability.
5. Raise international regulatory standards and improve international cooperation by
establishing international reforms to support efforts in the U.S., including
strengthening the capital framework; improving oversight of global financial
markets; coordinating supervision of internationally active firms; and enhancing
crisis management tools.
Industry Performance
Table 2–9 presents selected performance ratios for the commercial banking industry
for various years from 1989 through 2012. With the economic expansion in the U.S.
economy and falling interest rates throughout most of the 1990s, U.S. commercial
banks flourished for most of that period. In 1999 commercial bank earnings were
Chapter 2
TABLE 2–9
Financial Services: Depository Institutions
45
Selected Indicators for U.S. Commercial Banks, 1989 through 2012
Sources: FDIC, Quarterly Banking Profile, various issues; and Historical Statistics, 1989. www.fdic.gov
2012*
2010
2009
2008
2007
Number of institutions 6,168
6,530
6,840 7,086 7,283
Return on assets (%)
1.02
0.65 ⫺0.10
0.13
0.93
Return on equity (%)
9.06
5.86 ⫺0.93
1.33
9.12
Provision for loan losses
to total assets (%)
0.30
1.21
1.94
1.30
0.54
Net charge-offs to
loans (%)
1.17
2.67
2.60
1.32
0.62
Asset growth rate (%)
4.03
2.05 ⫺3.95 10.15 10.75
Net operating income
growth (%)
11.94 1,088.1 ⫺137.98 ⫺80.48 ⫺21.21
Number of failed/
assisted institutions
34
139
120
25
2
2006 2003
2001
2000 1999
1989
7,450 7,769 8,079 8,315 8,580 12,709
1.33 1.40
1.15 1.19 1.31
0.49
13.02 15.34 13.09 14.07 15.31
7.71
0.26
0.47
0.67
0.47
0.38
0.94
0.41
11.63
0.89
7.42
0.95
4.91
0.64
8.79
0.61
5.37
1.16
5.38
11.19 14.92 ⫺1.89
0
3
3
2.02 20.42 ⫺38.70
6
7
206
* Through September.
a record $71.6 billion. More than two-thirds of all U.S. banks reported a return on
assets (ROA) of 1 percent or higher, and the average ROA for all banks was 1.31
percent, up from 1.19 percent for the year 1998.9 This, despite continued financial problems (or sovereign risk, see Chapter 14) in Southeast Asia, Russia, and
South America. With the economic downturn in the early 2000s, however, bank
performance deteriorated slightly. For example, commercial banks’ string of eight
consecutive years of record earnings ended in 2000 as their net income fell to
$71.2 billion. Banks’ provision for loan losses (or credit risk) rose to $9.5 billion in
the fourth quarter of 2000, an increase of $3.4 billion (54.7 percent) from the level of
a year earlier. This was the largest quarterly loss provision since the fourth quarter
of 1991. Finally, the average ROA was 1.19 in 2000, down from 1.31 percent in 1999.
This downturn was short-lived, however. In 2001, net income of $74.3 billion easily surpassed the old record of $71.6 billion, and net income rose further, to $106.3
billion, in 2003. Moreover, in 2003, both ROA and ROE (return on equity) reached
all-time highs of 1.40 percent and 15.34 percent, respectively. The two main sources
of earnings strength in 2003 were higher noninterest income (up $18.9 billion, 10.3
percent) and lower loan loss provisions (down $14.2 billion, or 27.6 percent). The
greatest improvement in profitability occurred at large institutions, whose earnings had been depressed in the early 2000s by losses on loans to corporate borrowers and by weakness in market-sensitive noninterest revenue. Only 5.7 percent of
all institutions were unprofitable in 2003, the lowest proportion since 1997.
Several explanations have been offered for the strong performance of commercial
banks during the early 2000s. First, the Federal Reserve cut interest rates 13 times
during this period. Lower interest rates made debt cheaper to service and kept
many households and small firms borrowing. Second, lower interest rates made
home purchasing more affordable. Thus, the housing market boomed throughout
the period. Third, the development of new financial instruments, such as credit
derivatives and mortgage-backed securities, helped banks shift credit risk from
their balance sheets to financial markets and other FIs such as insurance companies.
Finally, improved information technology helped banks manage their risk better.
9
ROA is calculated as net income divided by the book value of total assets. It reflects the earnings per
dollar of assets for the bank. ROE is calculated as net income divided by common equity of the bank and
measures the return to the bank’s common stockholders.
46
Part One
Introduction
provision for loan
losses
Bank management’s
recognition of
expected bad loans
for the period.
net charge-offs
Actual losses on loans
and leases.
net operating
income
Income before taxes
and extraordinary
items.
As interest rates rose in the mid-2000s, performance did not deteriorate significantly. Third quarter 2006 earnings represented the second-highest quarterly total
ever reported by the industry, and more than half of all banks reported higher earnings in the third quarter of 2006 than in the second quarter. However, increased
loan loss provisions, reduced servicing income, and lower trading revenue kept
net income reported by commercial banks from setting a new record for the full
year. Rising funding costs outstripped increases in asset yields for a majority of
banks. Further, mortgage delinquencies, particularly on subprime mortgages,
surged in the last quarter of 2006 as homeowners who had stretched themselves
financially to buy a home or refinance a mortgage in the early 2000s fell behind
on their loan payments. Loan losses at banks in Louisiana, Mississippi, and Texas
soared as businesses and consumers hit by Hurricanes Katrina and Rita defaulted
on loans. Despite these weaknesses, the industry’s core capital ratio increased to
10.36 percent, the highest level since new, risk-based capital ratios were implemented in 1993. Finally, no FDIC-insured banks failed during 2005 or 2006. Both
the number and assets of “problem” banks were at historical lows.
The performance of the late 1990s and early and mid-2000s was quite an
improvement from the recessionary and high interest rate conditions in which
the industry operated in the late 1980s. As reported in Table 2–9, the average
ROA and ROE for commercial banks in 2006 were 1.33 percent and 13.02 percent, respectively, compared with 1989 when the ROA and ROE averaged
0.49 percent and 7.71 percent, respectively. Provision for loan losses (bank
management’s expectations of losses on the current loan portfolio) to assets
ratio and net charge-offs (actual losses on loans and leases) to loans ratio averaged 0.26 percent and 0.41 percent, respectively, in 2006, versus 0.94 percent and
1.16 percent, respectively, in 1989. Net operating income (income before taxes
and extraordinary items) grew at an annualized rate of 11.19 percent in 2006 versus a drop of 38.70 percent in 1989. Finally, note that in 2006 no U.S. commercial
banks failed, versus 206 failures in 1989.
In the late 2000s, the U.S. economy experienced its strongest recession since
the Great Depression. Commercial banks’ performance deteriorated along with
the economy. For all of 2007, net income was $105.5 billion, a decline of $39.8 billion (27.4 percent) from 2006. Less than half of all institutions (49.2 percent)
reported increased earnings in 2007, the first time in 23 years that a majority of
institutions had not posted full year earnings increases. The average ROA for the
year was 0.93 percent, the lowest yearly average since 1991, and the first time
in 15 years that the industry’s annual ROA had been below 1 percent. Sharply
higher loss provisions and a very rare decline in noninterest income were primarily responsible for the lower industry profits. Things got even worse in 2008. Net
income for all of 2008 was $10.2 billion, a decline of $89.8 billion (89.8 percent)
from 2007. This was the lowest annual earnings total since 1989, when the industry earned $10.0 billion. The ROA for the year was 0.13 percent, the lowest since
1987. Almost one in four institutions (23.6 percent) was unprofitable in 2008, and
almost two out of every three institutions (62.8 percent) reported lower full-year
earnings than in 2007. Total noninterest income declined by $25.6 billion (11 percent) as a result of the industry’s first ever full-year trading loss ($1.8 billion), a
$5.8 billion (27.4 percent) decline in securitization income, and a $6.6 billion drop in
proceeds from sales of loans, foreclosed properties, and other assets. Net loan and
lease charge-offs totaled $38.0 billion in the fourth quarter, an increase of $21.7 billion (132.7 percent) from the fourth quarter of 2007, the highest charge-off rate
Chapter 2
net interest margin
(NIM)
Interest income minus
interest expense
divided by earning
assets.
Financial Services: Depository Institutions
47
in the 25 years that institutions have reported quarterly net charge-offs. Twenty
commercial banks failed or were assisted during the year, the largest number of
failed and assisted institutions in a year since 1993. At year-end, 252 institutions
were on the FDIC’s “Problem List,” up from 76 institutions at the end of 2007.
As the economy improved in the second half of 2009, so did commercial bank
performance. While rising loan-loss provisions continued to dominate industry
profitability, growth in operating revenues, combined with appreciation in securities values, helped the industry post an aggregate net profit. Commercial banks
earned $2.8 billion in net income in the third quarter of 2009, more than three
times the $879 million from 2008. Growth in net interest income, lower realized
losses on securities and other assets, higher noninterest income, and lower noninterest expenses, all contributed to the year-over-year increase in net income. The
average net interest margin (NIM, i.e., interest income minus interest expense
divided by earning assets) in the third quarter was 3.51 percent, the highest quarterly average since the third quarter of 2005. Almost two-thirds of all institutions
(62.1 percent) reported higher NIMs than in the second quarter. Realized losses on
securities and other assets totaled $4.1 billion, which was $3.8 billion less than the
$7.9 billion in losses the industry experienced a year earlier. Noninterest income
was $4.0 billion (6.8 percent) higher than 2008 due to net gains on loan sales (up
$2.7 billion) and servicing fees (up $1.9 billion). However, the industry was still
feeling the effects of the long recession. Provisions for loan and lease losses totaled
$62.5 billion, the fourth consecutive quarter that industry provisions had exceeded
$60 billion. Net charge-offs continued to rise for an 11th consecutive quarter. Commercial banks charged off $50.8 billion in the quarter, an increase of $22.6 billion
(80.5 percent) over the third quarter of 2008. Net charge-offs were higher than 2008
at 60 percent of all institutions. As a result, the full year 2009 ROA and ROE fell to
⫺0.10 and ⫺0.93, respectively. Further, 120 commercial banks failed in 2009. This
is the largest number of failures since 1992. The number of commercial banks on
the FDIC’s “Problem List” rose from 416 to 552 during the third quarter of 2009,
and total assets of “problem” institutions increased from $299.8 billion to $345.9
billion. Both the number and assets of “problem” institutions were at the highest
level since the end of 1993.
As the economy continued to slowly recover in 2010 through 2012, so did bank
performance. The 2010 industry ROA and ROE increased to 0.65 percent and 5.86
percent, respectively, the highest in three years. By 2012, industry ROA and ROE
increased to 1.02 percent and 9.06 percent, respectively. In 2012, more than half
(57.5 percent) of all institutions reported higher year-over-year net income, and
only 10 percent reported negative net income (the lowest level in five years). Provisions for loan losses declined for a third consecutive year, and the amount of
loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) declined for 11 consecutive quarters. The number of institutions on
the FDIC’s “Problem List” fell from 732 to 694, while assets of “problem” banks
declined from $282.4 billion to $262.2 billion. This is the smallest number of “problem” institutions since third-quarter 2009.
In addition to a changing economy, also certain to affect the future performance
of commercial banks (as well as savings institutions and credit unions) is the
extent to which banks adopt the newest technology (see Chapter 17), including
the extent to which industry participants embrace the Internet and mobile banking. Appendix 2D (located at the book’s website, www.mhhe.com/saunders8e)
provides a short summary of technology-based wholesale and retail services
48
Part One
Introduction
provided by banks and other FIs. The performance of banks that have invested
in Internet banking as a complement to their existing services has been similar
to the performance of those without Internet banking, despite relatively high initial technology-related expenses. In particular, banks that offer Internet banking
services generally have higher noninterest income (which offsets any increased
technology expenses). Further, the risk of banks offering Internet-related banking
products appears to be similar to the risk of those banks without Internet banking.
Concept
Questions
1. What are the major assets held by commercial banks?
2. What are the major sources of funding for commercial banks?
3. Describe the responsibilities of the three federal regulatory agencies in the United
States.
4. What are the major regulations that have affected the operations of U.S. commercial
banks?
5. What has the trend in ROA and ROE been in the commercial banking industry over
the last decade?
SAVINGS INSTITUTIONS
savings institutions
Depository institutions that specialize in
residential mortgages
mostly backed by
short-term deposits
and other funds.
Savings institutions were first created in the early 1800s in response to commercial
banks’ concentration on serving the needs of business (commercial) enterprises
rather than the needs of individuals requiring borrowed funds to purchase homes.
Thus, the first savings institutions pooled individual savings and invested them
mainly in mortgages and other securities. Today’s savings institutions, however,
generally perform services similar to those of commercial banks.
Savings institutions comprise two different groups of FIs: savings associations
(SAs) and savings banks (SBs). They usually are grouped together because they
not only provide important mortgage and/or lending services to households but
also are important recipients of household savings. Historically, savings associations have concentrated more on residential mortgages, while savings banks have
operated as relatively diversified savings institutions that have a large concentration of residential mortgage assets but hold some commercial loans, corporate
bonds, and corporate stock as well. In this section, we review these two groups.
Size, Structure, and Composition of the Industry
Savings associations were historically referred to as savings and loans (S&Ls)
associations. However, in the 1980s, federally chartered savings banks appeared
in the United States. The term savings association has replaced “S&L association” to
capture the resulting change in the structure of the industry.10 These institutions
have the same regulators as traditional savings and loans.
The savings association industry prospered throughout most of the 20th century. These specialized institutions made long-term residential mortgages backed
10
In 1978, the Federal Home Loan Bank Board (FHLBB), at the time the main regulator of savings associations, began chartering federal savings banks insured by the Federal Savings and Loan Insurance Corporation (FSLIC). In 1982, the FHLBB allowed S&Ls to convert to federal savings banks with bank (rather than
S&L) names. As more and more S&Ls converted to savings banks, the title associated with this sector of
the thrift industry was revised to reflect this change.
Chapter 2
disintermediation
Withdrawal of deposits from savings
associations and other
depository institutions and their reinvestment elsewhere.
Regulation Q
ceiling
An interest ceiling
imposed on small
savings and time
deposits at banks and
thrifts until 1986.
regulator
forbearance
A policy of not
closing economically
insolvent FIs, but
allowing them to
continue in operation.
mutual
organizations
Savings banks in
which the depositors are also the legal
owners of the bank.
Financial Services: Depository Institutions
49
by short-term savings deposits. At the end of the 1970s, slightly fewer than 4,000
savings associations had assets of approximately $0.6 trillion. Over the period
October 1979 to October 1982, however, the Federal Reserve’s restrictive monetary
policy action led to a sudden and dramatic surge in interest rates, with rates on
T-bills rising as high as 16 percent. This increase in short-term rates and the cost of
funds had two effects. First, savings associations faced negative interest spreads
or net interest margins in funding much of their fixed-rate long-term residential
mortgage portfolios over this period. Second, they had to pay more competitive
interest rates on savings deposits to prevent disintermediation and the reinvestment of those funds in money market mutual fund accounts. Their ability to
do this was constrained by the Federal Reserve’s Regulation Q ceilings, which
limited the rates savings associations could pay on traditional passbook savings
account and retail time deposits.
In part to overcome the effects of rising rates and disintermediation on the savings association industry, Congress passed two acts, the DIDMCA and the DIA (see
Table 2–8). These acts expanded the deposit-taking and asset-investment powers
of savings associations. For many savings associations, the new powers created
safer and more diversified institutions. For a small but significant group whose
earnings and shareholders’ capital were being eroded in traditional lines of business, this created an opportunity to take more risks in an attempt to return to profitability. However, in the mid-1980s, real estate and land prices in Texas and the
Southwest collapsed. This was followed by economic downturns in the Northeast
and in western states of the United States. Many borrowers with mortgage loans
issued by savings associations in these areas defaulted. In other words, the credit
or lending risks incurred by savings associations in these areas often failed to pay
off. This risk-taking, or moral hazard, behavior was accentuated by the policies of
the savings association insurer, the FSLIC. Due to a lack of funds, the FSLIC could
not close many of the capital-depleted, economically insolvent savings associations
(a policy of regulator forbearance) and maintained deposit insurance premium
assessments independent of the risk of the savings institution (see Chapter 19). As
a result, there was an increasing number of failures in the 1982–89 period aligned
with rapid asset growth of the industry. Thus, savings associations decreased in
number from 4,000 in 1980 to 2,600 in 1989, or by 35 percent (however, their assets
actually doubled from $600 billion to $1.2 trillion over that period).
Traditionally, savings banks were established as mutual organizations (in
which the depositors are also legally the owners of the bank) in states that permitted such organizations. These states were largely confined to the East Coast—for
example, New York, New Jersey, and the New England states. As a result, savings
banks (unlike savings associations) were not as affected by the oil-based economic
shocks that impacted Texas and the Southwest in the 1980s. Nevertheless, the
crash in New England real estate values in 1990–91 presented equally troubling
problems for this group. Indeed, many of the failures of savings institutions in the
early 1990s were savings banks rather than savings associations. As a result, savings banks have decreased in both size and number.
Figure 2–6 shows the number of failures, mergers, and new charters of savings
institutions from 1984 through 2012. Notice the large number of failures from 1987
through 1992 and the decline in the number of new charters. These failures, especially in 1988 and 1989, depleted the resources of the FSLIC to such an extent that
by 1989 it was massively insolvent (see Chapter 19). Resulting legislation—the
FIRREA of 1989—abolished the FSLIC and created a new insurance fund (SAIF)
50
Part One
Introduction
FIGURE 2–6 Structural Changes in the Number of Savings Institutions, 1984–2012
Source: Federal Deposit Insurance Corporation, Quarterly Banking Profile, various years. www.fdic.gov
Number
300
Failures
Mergers
New charters
250
200
150
100
50
0
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
Year
QTL test
Qualified thrift lender
test that sets a floor on
the mortgage related
assets held by thrifts
(currently 65 percent).
under the management of the FDIC. In addition, the act created the Resolution
Trust Corporation (RTC) to close the most insolvent savings associations.11
Further, the FIRREA strengthened the capital requirements of savings institutions and constrained their non-mortgage-related asset-holding powers under a
newly imposed qualified thrift lender, or QTL, test. In 1991, Congress enacted the
FDICIA. FDICIA introduced risk-based deposit insurance premiums (starting in
1993) in an attempt to limit excess risk taking by savings institutions. It also introduced a prompt corrective action (PCA) policy, such that regulators could close
thrifts (and banks) faster (see Chapter 20). In particular, if a savings institution’s
ratio of its equity capital to its assets falls below 2 percent, it has to be closed down
or recapitalized within three months.
As a result of the closing of weak savings institutions and the strengthening
of capital requirements, the industry shrunk significantly, both in numbers and
in asset size, in the 1990s. Savings institutions decreased in number from 3,677
in 1989 to 2,262 in 1993 (by 38 percent), and assets shrank from $1.427 trillion to
$1.001 trillion (by 30 percent) over that same period.
Balance Sheet and Recent Trends
Even in its new streamlined state, concerns have been raised about the future
viability of the savings institution industry in traditional mortgage lending areas.
This is partly due to intense competition for mortgages from other financial
11
At the time of its dissolution in 1995, the RTC had resolved or closed more than 700 savings
institutions, at an estimated cost of $200 billion to the U.S. taxpayers.
Chapter 2
Financial Services: Depository Institutions
51
institutions, such as commercial banks and specialized mortgage bankers. It is
also due to the securitization of mortgages into mortgage-backed security pools
by government-sponsored enterprises, which we discuss further in Chapter 26.12
In addition, long-term mortgage lending exposes an FI to significant credit, interest rate, and liquidity risks.
Table 2–10 shows the balance sheet of savings institutions in 2012. On this balance sheet, mortgages and mortgage-backed securities (securitized pools of mortgages) account for 65.63 percent of total assets. This compares with 27.31 percent
in commercial banks. As noted earlier, the FDICIA uses the qualified thrift lender
(QTL) test to establish a minimum holding of 65 percent in mortgage-related
assets for savings institutions. Reflecting the enhanced lending powers established
under the 1980 DIDMCA and the 1982 DIA, commercial loans and consumer loans
amounted to 4.66 and 7.65 percent of assets, respectively, in 2012. Finally, savings
institutions are required to hold cash and investment securities for liquidity risk
purposes and to meet regulator-imposed reserve requirements. In September 2012,
cash and U.S. Treasury securities holdings amounted to 10.14 percent of total
assets, compared with 22.45 percent at commercial banks.
On the liability side of the balance sheet, small time and savings deposits
are still the predominant source of funds, with total deposits accounting for
76.48 percent of total liabilities and net worth. The second most important source
of funds consists of borrowings from the Federal Home Loan Banks (FHLBs), of
which there are 12. These banks in turn are owned by the savings institutions
themselves. Because of their size and government-sponsored status, FHLBs have
access to wholesale money markets and the capital market for notes and bonds
TABLE 2–10
Assets and
Liabilities of
Savings Institutions,
September 30, 2012
Source: FDIC, December
2012. www.fdic.gov
Cash and due from
U.S. Treasury securities
Mortgage loans
MBS (includes CMOs, POs, IOs)
Bonds, notes, debentures, and other securities
Commercial loans
Consumer loans
Other loans and financing leases
Less: Allowance for loan losses and unearned income
Other assets
Millions of
Dollars
$ 110,454
6,398
517,525
239,214
59,130
53,730
88,192
17,609
(10,353)
71,181
Percent
9.58%
0.56
44.88
20.75
5.12
4.66
7.65
1.53
(0.90)
6.17
Total assets
Total deposits
Other borrowings
Federal funds and repurchase agreements
Other liabilities
$1,153,080
$881,859
83,377
30,920
19,861
100.00%
76.48%
7.23
2.68
1.72
1,016,017
137,063
88.11
11.89
Total liabilities
Net worth
Total liabilities and net worth
Number of institutions
12
The major enterprises are GNMA, FNMA, and FHLMC.
$1,153,080
100.00%
1,013
52
Part One
Introduction
and can relend the funds borrowed on these markets to savings institutions at a
small markup over wholesale cost. Other borrowed funds include repurchase
agreements and direct federal fund borrowings. Finally, net worth, the book value
of the equity holders’ capital contribution, amounted to 11.89 percent of total
assets in 2012. This compares with 11.48 percent at commercial banks.
Regulation
The main regulators of savings institutions are the Office of the Comptroller of the
Currency (OCC) and the FDIC.
www.occ.gov
The Office the Comptroller of the Currency
In 1989 FIRREA established the Office of Thrift Supervision. This office chartered
and examined all federal savings institutions. Further, when savings institutions
were held by parent holding companies, the OTS supervised the holding companies as well. During the financial crisis the U.S. Congress determined that savings
bank regulators performed relatively weakly compared with commercial bank
regulators. Further, a Government Accountability Office report noted that some
of the savings institutions regulated by the OTS were primarily operating in areas
other than those traditionally engaged by thrifts, i.e., insurance, securities, and
commercial activities. To address these concerns, the Wall Street Reform and Consumer Protection Act mandated the consolidation of the Office of Thrift Supervision with the Office of the Comptroller of the Currency. As a result, the OTS
became part of the OCC on July 21, 2011, and on October 19, 2011, the OTS ceased
to exist. Thus, the OCC now regulates both national banks and federal savings
institutions. Additionally, the bill did not eliminate the charter for savings institutions dedicated to mortgage lending, but did subject savings institution holding
companies to supervision by the Federal Reserve.
www.fdic.gov
The FDIC-DIF Fund
Also established in 1989 under the FIRREA and in the wake of the FSLIC insolvency, the FDIC oversaw and managed the Savings Association Insurance Fund
(SAIF). In 1996, as part of a plan to recapitalize the SAIF, commercial banks were
required to pay for part of the burden. In return, Congress promised to eventually
merge bank and thrift charters (and hence insurance funds) into one. In January
2007, the FDIC merged the SAIF and the Bank Insurance Fund (BIF) to form the
Deposit Insurance Fund (DIF). Thus, thrifts now operate under the same regulatory structure that applies to commercial banks.
Other Regulators
State-chartered savings institutions (the vast majority) are regulated by state agencies. Savings institutions that adopt federal charters are subject to the regulations
of the OTS.
Industry Performance
Like commercial banks, savings institutions experienced record profits in the midto late-1990s as interest rates (and thus the cost of funds to savings institutions)
remained low and the U.S. economy expanded. The result was an increase in the
spread between interest income and interest expense for savings institutions and
consequently an increase in their net income. In 1999, savings institutions reported
$10.7 billion in net income and an annualized ROA of 1.00 percent (this compares
Chapter 2
Financial Services: Depository Institutions
53
with an ROA of 1.31 percent over the same period for commercial banks). Only the
$10.8 billion of net income reported in 1998 exceeded these results. Asset quality
improvements were widespread during 1999, providing the most favorable net
operating income that the industry had ever reported. However, as in the commercial banking industry, the downturn in the U.S. economy also resulted in a
decline in savings institutions’ profitability in 2000. Specifically, their ROA and
ROE ratios fell slightly in 2000 to 0.92 percent and 11.14 percent, respectively, from
their 1999 levels. Again, as with commercial banks, despite an economic recession, this downturn was short-lived. Both ROA and ROE increased to record levels each year from 2001 through 2003. The industry’s net interest margins rose: the
cost of funding earning assets declined by 2.70 percent while the yield on earning
assets declined by only 2.35 percent. However, net charge-offs in 2003 were almost
twice those in 2000. A flat yield curve and increased funding costs contributed to
decreased margins in the mid-2000s. The average ROA declined to 1.15 percent in
2005 and 0.99 percent in 2006, while ROE decreased to 10.40 percent in 2005 and
8.68 percent in 2006. Table 2–11 presents several performance ratios for the industry for various years from 1989 through 2012.
In the late 2000s, as the U.S. economy experienced its strongest recession
since the Great Depression, savings institutions’ performance deteriorated. For
all of 2007, net income was $6.0 billion, down $11.1 billion from 2006. The average ROA for the year was 0.13 percent, the lowest yearly average since 1989.
In 2008, net income was ⫺$8.6 billion. This was the first negative earnings year
since 1991. The ROA for the year was ⫺0.72 percent. However, only six savings
institutions failed or were assisted during the year. In this group was Washington
Mutual the largest savings institution, with over $300 billion in assets. At yearend, 18 savings institutions were on the FDIC’s “Problem List,” up from six institutions at the end of 2007. Like commercial banks, as the economy improved in
the second half of 2009 through 2012, so did savings institution performance.
Savings institutions earned $1.4 billion in net income in the third quarter of 2009,
up from ⫺$18.3 million in the second quarter. This trend continued into 2010 as
savings institutions earned $8.3 billion for the year, ROA for the industry was
0.65 percent, and ROE was 5.76 percent—up from 0.14 percent and 1.31 percent,
TABLE 2–11
Selected Indicators for U.S. Savings Institutions, 1989 through 2012
Source: FDIC, Quarterly Banking Profile, various issues, and Historical Statistics, 1989. www.fdic.gov
2012*
2010
2009
2008
2007
2006
2005
2003
2001
2000
1999
1989
Number of institutions
1,013 1,128
1,172
1,219
1,251 1,279 1,307 1,413 1,535 1,590 1,642
3,677
Return on assets (%)
1.01
0.65
0.14
⫺0.72
0.13
0.99
1.15
1.28
1.07
0.92
1.00 ⫺0.39
Return on equity (%)
8.61
5.76
1.31
⫺7.75
1.08
8.68 10.40 13.66 12.33 11.14 11.73 ⫺8.06
Noncurrent assets
plus other real estate
owned to assets (%)
2.30
3.04
3.00
2.40
1.46
0.63
0.57
0.62
0.65
0.56
0.58
2.78
Asset growth rate (%) ⫺7.60 ⫺0.84 ⫺17.50 ⫺17.53
4.97 ⫺3.70
8.64
8.49
8.17
6.41
5.60 ⫺11.14
Net operating income
growth (%)
35.69 273.16 120.37 ⫺456.80 ⫺81.68 ⫺9.84
8.03 23.07
6.64
3.55 16.70 ⫺58.95
Number of failed/
assisted institutions
9
18
20
6
1
0
0
0
1
1
1
331
* Through September.
54
Part One
TABLE 2–12
Introduction
U.S. Savings Institution Asset Concentration, 1992 versus 2012
Source: FDIC Quarterly Banking Profile, various issues. www.fdic.gov
2012
All FDIC-insured savings
institutions
1. Under $100 million
2. $100 million–$1 billion
3. $1 billion–$10 billion
4. $10 billion or more
1992
Number
Percent
of Total
Assets*
Percent
of Total
1,013
253
627
105
28
25.0%
61.9
10.4
2.7
$1,153.1
14.3
219.1
218.5
701.1
1.2%
19.0
19.0
60.8
Number
2,391
1,109
1,093
181
8
Percent
of Total
Assets*
Percent
of Total
46.4%
45.7
7.6
0.3
$1,035.2
55.9
315.3
479.5
184.5
5.4%
30.5
46.3
17.8
* In billions of dollars.
respectively, in 2009. By 2012, the industry ROA was 1.01 percent and ROE was
8.61 percent. Further, 9 savings institutions failed in 2012, down from 20 in 2009
and 18 in 2010.
Also like commercial banks, savings institutions experienced substantial consolidation in the 1990s. For example, the 1998 acquisition of H. F. Ahmanson & Co.
by Washington Mutual Inc. for almost $10 billion was the fourth-largest
bank–thrift merger completed in 1998.13 Washington Mutual was the third-largest
savings institutions in the United States early in 1997, while Ahmanson was the
largest savings institution. In 1997, Washington Mutual bought Great Western,
to become the largest thrift in the country. Then, in March 1998, Washington
Mutual bought Ahmanson to combine the two largest U.S. thrifts. However, as
mentioned above, Washington Mutual became a victim of the mortgage market
meltdown and was seized by regulators in September 2008. The bulk of the institution’s operations were sold to J.P. Morgan Chase. Table 2–12 shows the industry
consolidation in number and asset size over the period 1992–2012. Notice that
over this period, the biggest savings institutions (over $10 billion in assets) grew
in number from 8 to 28 and their control of industry assets grew from 17.8 percent
to 60.8 percent.
Concept
Questions
1. Are savings institutions likely to be more or less exposed to interest rate risk than are
banks? Explain your answer.
2. How do adjustable-rate mortgages help savings institutions?
3. Why should savings institutions with little or no equity capital seek to take more risk
than well-capitalized savings institutions?
4. Why could it be argued that the QTL test makes savings institutions more rather than
less risky?
5. Describe the recent performance of savings institutions.
6. Describe the ways that profit trends for savings institutions have been similar to those
of commercial banks in the 1990s through the 2010s.
13
Behind Travelers Group–Citigroup ($74 billion), NationsBank–BankAmerica ($67 billion), and BankOne–
First Chicago NBD ($30 billion).
Chapter 2
Financial Services: Depository Institutions
55
CREDIT UNIONS
credit unions
Nonprofit depository
institutions, owned
by members with
a common bond,
specializing in small
consumer loans.
Credit unions (CUs) are nonprofit depository institutions mutually organized and
owned by their members (depositors). Credit unions (CUs) were first established
in the United States in the early 1900s as self-help organizations intended to alleviate widespread poverty. The first credit unions were organized in the Northeast,
initially in Massachusetts. Members paid an entrance fee and invested funds to
purchase at least one deposit share in the CU. Members were expected to deposit
their savings in the CU, and these funds were lent only to other members.
This limit in the customer base of CUs continues today as, unlike commercial
banks and savings institutions, CUs are prohibited from serving the general public. Rather, in organizing a credit union, members are required to have a common bond of occupation (e.g., police CUs) or association (e.g., university-affiliated
CUs), or to cover a well-defined neighborhood, community, or rural district. CUs
may, however, have multiple groups with more than one type of membership.
The primary objective of credit unions is to satisfy the depository and lending
needs of their members. CU member deposits (shares) are used to provide loans
to other members in need of funds. Any earnings from these loans are used to pay
higher rates on member deposits, charge lower rates on member loans, or attract
new members to the CU. Because credit unions do not issue common stock, the
members are legally the owners of a CU. Also, because credit unions are nonprofit organizations, their net income is not taxed and they are not subject to the
local investment requirements established under the 1977 Community Reinvestment Act. This tax-exempt status allows CUs to offer higher rates on deposits, and
charge lower rates on some types of loans, than do banks and savings institutions.
This is shown in Figure 2–7 for the period 1991–2012.
Size, Structure, and Composition of the Industry
Credit unions are the most numerous of the institutions that make up the depository institutions segment of the FI industry, totaling 7,219 in 2012. Moreover, they
were less affected by the crises that impacted commercial banks and savings institutions in the 1980s and late 2000s14 because traditionally, more than 40 percent of
their assets have been in the form of small consumer loans, often for amounts less
than $10,000. In addition, CUs tend to hold large amounts of government securities
(19.9 percent of their assets in 2012) and relatively small amounts of residential
mortgages. Their lending activities are funded by savings deposits contributed by
more than 95 million members who share some common thread or bond of association, usually geographic or occupational in nature. As a result, in 2008 at the height
of the financial crisis, while commercial banks’ and savings institutions’ average
ROAs were 0.13 and ⫺0.72 percent, respectively, credit unions saw an average
ROA of 0.31 percent.
To attract and keep customers, CUs have had to expand their services to compete
with those of commercial banks and savings institutions. For example, CUs now
offer products and services ranging from mortgages and auto loans (their traditional
services) to credit lines and mobile banking. Some credit unions now offer business
14
Credit unions have been covered by federal deposit insurance guarantees since 1971 (under the
National Credit Union Share Insurance Fund). The depositor coverage cap of $250,000 is the same as
that which currently exists for both commercial banks and savings institutions.
56
Part One
Introduction
FIGURE 2–7 Credit Union versus Bank Interest Rates
Source: National Credit Union Administration, December 2012. www.ncua.gov
12%
New Car Loans
10
Banks
8
Credit
unions
6
Credit
unions
4
Banks
1-Year
CDs
2
1991
1993
www.aba.com
1995
1997
1999
2001
Year
2003
2005
2007
2009
2011
and commercial loans to their employer groups. For example, in 2012, business
loans represented 5.1 percent of the industry’s lending. Because of their tax-exempt
status, CUs can charge lower rates on these loans, providing CUs with a cost advantage over banks and savings institutions that is very attractive to customers.
As CUs have expanded in number, size, and services, bankers have claimed that
CUs are unfairly competing with small banks that have historically been the major
lenders in small towns. For example, the American Bankers Association has stated
that the tax exemption for CUs gives them the equivalent of a $1 billion per year
subsidy. The Credit Union National Association’s (CUNA) response is that any
cost to taxpayers from CUs’ tax-exempt status is more than made up in benefits
to members and therefore the social good they create. CUNA estimates that the
benefits of CU membership can range from $200 to $500 a year per member or, with
more than 95 million members, a total benefit of $19 billion to $47.5 billion per year.
In 1997 the banking industry filed two lawsuits in its push to narrow the widening membership rules governing credit unions that followed a 1982 legal interpretation of the original 1934 Federal Credit Union Act’s definition of what constitutes
a “group having a common bond of occupation or association.” The first lawsuit
(filed by four North Carolina banks and the American Bankers Association) challenged the ability of an occupation-based credit union (the AT&T Family Credit
Union based in North Carolina) to accept members from companies unrelated to
the firm that originally sponsored the CU. In the second lawsuit, the American
Bankers Association asked the courts to bar the federal government from letting
Chapter 2
Financial Services: Depository Institutions
57
occupation-based credit unions convert to community-based charters. Bankers
argued in both lawsuits that such actions, broadening the membership of credit
unions under other than occupation-based guidelines, would further exploit an
unfair advantage allowed by the credit unions’ tax-exempt status. In February
1998 the Supreme Court sided with banks, stating that credit unions could no
longer accept members who did not share the common bond of membership. In
April 1998, however, the U.S. House of Representatives overwhelmingly passed
a bill that allowed all existing members to keep their credit union accounts. The
bill was passed by the Senate in July 1998 and signed into law by the president in
August 1998. This legislation allowed CUs not only to keep their existing members but also to accept new groups of members—including small businesses and
low income communities—that were not considered part of the “common bond”
of membership by the Supreme Court ruling.
In another hit to commercial banks, credit unions saw record increases in
membership in late 2011 and early 2012, with most of the increase coming from
commercial bank customers. For the year ending June 30, 2012, credit union membership increased by nearly 2.2 million new members: almost twice the 1.2 million
average annual growth experienced in similar 12-month periods over the previous 10 years and four times greater than the 550,000 new members over that same
period the prior year. Much of the growth in membership occurred as a part of
nationwide campaigns—such as Bank Transfer Day on November 5, 2011—that
encouraged consumers to leave their “big” banks for credit unions and community
banks, which tend to incur fewer fees. Among the catalysts for these campaigns
was Bank of America’s plan to impose a monthly fee for debit card use. The plan
was scrapped after seeing the strong negative reactions from consumers.
Balance Sheet and Recent Trends
Table 2–13 shows the assets and liabilities for credit unions in June 2012. In
that year 7,219 credit unions had assets of $1,012.8 billion. This compares with
$155 billion in assets in 1987. Individually, credit unions tend to be very small,
with an average size of $140.3 million in 2012 compared with $2,112.8 million for
banks. The total assets of all credit unions are less than half the size of those of the
largest U.S. banking organization, J.P. Morgan Chase.
Given their emphasis on retail or consumer lending, discussed above, 23.8 percent of CU assets are in the form of small consumer loans and another 28.1 percent
are in the form of home mortgages. Together, these member loans constitute
51.9 percent of total assets. Because of the common bond requirement on credit
union customers, relatively few business or commercial loans are issued by CUs.
Credit unions also invest heavily in investment securities (28.3 percent of total
assets in 2012). Further, 70.2 percent of the investment portfolios of CUs are in
U.S. government Treasury securities or federal agency securities. Their investment
portfolio composition, along with their cash holdings (9.5 percent of total assets),
allow credit unions ample liquidity to meet their daily cash needs—such as share
(deposit) withdrawals. Some CUs have also increased their off-balance-sheet
activities. Specifically, unused loan commitments, including credit card limits and
home equity lines of credit, totaled more than $152 billion in 2012.
Credit union funding comes mainly from member deposits (85.9 percent of
total funding in 2012). Figure 2–8 presents the distribution of these deposits in
2012. Regular share draft transaction accounts (similar to NOW accounts at other
depository institutions) accounted for 32.3 percent of all CU deposits, followed
58
Part One
Introduction
TABLE 2–13
Assets and
Liabilities of Credit
Unions, September
2012
Source: National Credit Union
Administration, December
2012. www.ncua.gov
Billions of Dollars
Assets
Cash and equivalents
Investment securities:
U.S. government securities
Treasury
Agency
Mortgage-backed securities
Other investment securities
$
95.7
Percentage
9.5%
11.6
190.0
49.7
35.9
1.1
18.8
4.9
3.5
Total investment securities
287.2
28.3
Loans:
Home mortgages
Consumer loans
Business loans
Other
(Allowance for loan losses)
285.0
241.4
40.8
23.9
(8.3)
28.1
23.8
4.0
2.4
(0.8)
Total loans
582.8
57.5
47.1
Other assets
4.7
Total assets
$1,012.8
100.0%
Liabilities and Equity
Share drafts
Small time and savings
Large time
$ 109.7
687.0
73.0
10.8%
67.9
7.2
Shares/deposits
$ 869.7
85.9%
Other loans and advances
Miscellaneous liabilities
26.3
12.0
2.6
1.2
Total liabilities
$ 908.0
89.7%
Total ownership shares
$ 104.8
10.3%
FIGURE 2–8
Composition of
Credit Union
Deposits, 2012
Regular
shares
32.3%
CDs
23.2%
Source: Credit Union
National Association, Credit
Union Report Mid-Year 2012.
www.cuna.org
Money market
shares 22.8%
IRAs and Keogh
accounts 9.1%
Share drafts
12.6%
by certificates of deposits (23.2 percent of deposits), money market accounts
(22.8 percent of deposits) and share drafts (similar to passbook savings accounts
at other depository institutions, but so named to designate the deposit holders’
ownership status) (12.6 percent of deposits). Credit unions hold lower levels of
Chapter 2
Financial Services: Depository Institutions
59
equity than other depository institutions. Since CUs are not stockholder owned,
this equity is basically the accumulation of past profits from CU activities that are
“owned” collectively by member depositors. As we will discuss in Chapters 7 and
20, this equity protects a CU against losses on its loan portfolio as well as against
other financial and operating risks. However, these risks are generally lower for
credit unions than commercial banks and savings institutions. In June 2012, CUs’
capital-to-assets ratio was 10.35 percent compared with 11.89 percent for savings
institutions and 11.48 percent for commercial banks.
Regulation
www.ncua.gov
www.cuna.org
Like commercial banks and savings institutions, credit unions can be federally
or state chartered. As of 2012, 60.5 percent of the 7,219 CUs were federally chartered and subject to National Credit Union Administration (NCUA) regulation,
accounting for 54.0 percent of the total credit union membership and 53.5 percent
of total assets. In addition, through its insurance fund (the National Credit Union
Share Insurance Fund, or NCUSIF), the NCUA provides deposit insurance guarantees of up to $250,000 for insured credit unions. Currently, the NCUSIF covers
98 percent of all credit union deposits.
Industry Performance
Like other depository institutions, the credit union industry grew in asset
size in the 1990s and 2000s. Asset growth from 1999 to 2012 was more than
7.5 percent annually. In addition, CU membership increased from 77.5 million
to over 95.3 million over the 1999–2012 period. Asset growth was especially pronounced among the largest CUs (with assets of more than $500 million) as their
assets increased by 20 percent annually from 1999 through 2012. Figure 2–9 shows
FIGURE 2–9
Return on Assets for Credit Unions, 1993 through 2012
Source: National Credit Union Association, Year-End Statistics, 2013. www.ncua.gov
ROA (%)
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
60
Part One
Introduction
the trend in ROA for CUs from 1993 through 2012. The decrease in ROA over the
period is mostly attributed to earnings decreases at the smaller CUs. For example,
the largest credit unions experienced an ROA of 0.95 percent in the first six months
of 2012, while for the smallest CUs (with assets of less than $5 million) the ROA
was ⫺0.11 percent. ROA for the whole industry was 0.84 percent. Smaller CUs
generally have a smaller customer base with which to issue quality loans and have
higher overhead expenses per dollar of assets. Thus, their ROAs have been hurt.
Given the mutual-ownership status of this industry, however, growth in ROA
(or profits) is not necessarily the primary goal of CUs. Rather, as long as capital or
equity levels are sufficient to protect a CU against unexpected losses on its credit
portfolio as well as other financial and operational risks, this not-for-profit industry has a primary goal of serving the deposit and lending needs of its members.
This contrasts with the emphasis placed on profitability by stockholder-owned
commercial banks and savings institutions.
Concept
Questions
1. How do credit unions differ from commercial banks and savings institutions?
2. Why did credit unions prosper in the 1980s and late 2000s compared with commercial banks and savings institutions?
3. What is the major asset held by credit unions?
4. Why do commercial banks and savings institutions claim that credit unions have an
unfair advantage in providing bank services?
GLOBAL ISSUES: THE FINANCIAL CRISIS
£ ¥
:$
Soon after it hit the United States, the financial crisis spread worldwide. As the
crisis quickly spread, banks worldwide saw losses driven by their portfolios of
structured finance products and securitized exposures to the subprime mortgage
market. Losses were magnified by illiquidity in the markets for those instruments.
As with U.S. banks, this led to substantial losses in their marked-to-market valuations. In Europe, the general picture of bank performance in 2008 was similar to
that in the United States. That is, net income fell sharply at all banks. The largest
banks in the Netherlands, Switzerland, and the United Kingdom had net losses
for the year. Banks in Ireland, Spain, and the United Kingdom were especially
hard hit as they had large investments in mortgages and mortgage-backed securities, both U.S. and domestic. Because they focused on domestic retail banking,
French and Italian banks were less affected by losses on mortgage-backed securities. Continental European banks, in contrast to U.K. banks, partially cushioned
losses through an increase in their net interest margins.
A number of European banks averted outright bankruptcy thanks to direct support from their central banks and national governments. During the last week of
September and first week of October 2008, the German government guaranteed
all consumer bank deposits and arranged a bailout of Hypo Real Estate, the country’s second largest commercial property lender. The United Kingdom nationalized mortgage lender Bradford & Bingley (the country’s eighth largest mortgage
lender) and raised deposit guarantees from $62,220 to $88,890 per account. Ireland
guaranteed deposits and debt of its six major financial institutions. Iceland rescued its third largest bank with an $860 million purchase of 75 percent of the
Chapter 2
Financial Services: Depository Institutions
61
bank’s stock and a few days later seized the country’s entire banking system. The
Netherlands, Belgium, and Luxembourg central governments together agreed to
inject $16.37 billion into Fortis NV (Europe’s first ever cross-border financial services company) to keep it afloat. However, five days later this deal fell apart, and
the bank was split up. The Dutch bought all assets located in the Netherlands for
approximately $23 billion. The central bank in India stepped in to stop a run on
the country’s second largest bank, ICICI Bank, by promising to pump in cash.
Central banks in Asia injected cash into their banking systems as banks’ reluctance
to lend to each other led the Hong Kong Monetary Authority to inject liquidity
into its banking system after rumors led to a run on Bank of East Asia Ltd. South
Korean authorities offered loans and debt guarantees to help small and midsize
businesses with short-term funding. The United Kingdom, Belgium, Canada,
Italy, and Ireland were just a few of the countries to pass an economic stimulus
plan and/or bank bailout plan. The Bank of England lowered its target interest
rate to a record low of 1 percent, hoping to help the British economy out of a recession. The Bank of Canada, Bank of Japan, and Swiss National Bank also lowered
their main interest rate to 1 percent or below. All of these actions were a result of
the spread of the U.S. financial market crisis to world financial markets.
However, the worldwide economic slowdown experienced in the later stages of
the crisis meant that bank losses have become more closely connected to macroeconomic performance. Countries across the world saw companies scrambling
for credit and cutting their growth plans. Additionally, consumers worldwide
reduced their spending. Even China’s booming economy slowed more than had
been predicted, from 10.1 percent in the second quarter of 2008 to 9 percent in the
third quarter. This was the first time since 2002 that China’s growth was below
10 percent and dimmed hopes that Chinese demand could help keep world economies growing. In late October, the global crisis hit the Persian Gulf as Kuwait’s central bank intervened to rescue Gulf Bank, the first bank rescue in the oil rich Gulf.
Until this time, the area had been relatively immune to the world financial crisis.
However, plummeting oil prices (which had dropped over 50 percent between
July and October 2008) left the area’s economies vulnerable. In this period, the
majority of bank losses were more directly linked to a surge in borrower defaults
and to anticipated defaults as evidenced by the increase in the amount and relative importance of loan loss provision expenses.
International banks’ balance sheets continued to shrink during the first half
of 2009 (although at a much slower pace than in the preceding six months) and,
as in the United States, began to recover in the latter half of the year. In the
fall of 2009, a steady stream of mostly positive macroeconomic news reassured
investors that the global economy had turned around, but investor confidence
remained fragile. For example, in late November 2009, security prices worldwide
dropped sharply as investors reacted to news that government-owned Dubai
World had asked for a delay in some payments on its debt. Further, throughout
the spring of 2010, Greece struggled with a severe debt crisis. Early on, some of
the healthier European countries tried to step in and assist the debt-ridden country. Specifically, in March 2010, a plan led by Germany and France to bail out
Greece with as much as $41 billion in aid began to take shape. However, in late
April 2010, Greek bond prices dropped dramatically as traders began betting
a debt default was inevitable, even if the country received a massive bailout.
The sell-off was the result of still more bad news for Greece, which showed that
the 2009 budget deficit was worse than had been previously reported, and as a
62
Part One
Introduction
result, politicians in Germany began to voice opposition to a Greek bailout. Further, Moody’s Investors Service downgraded Greece’s debt rating and warned
that additional cuts could be on the way. Greece’s debt created heavy losses
across the Greek banking sector. A run on Greek banks ensued. Initially, between
:100 and :500 million per day was being withdrawn from Greek banks. At its
peak, the run on Greek banks produced deposit withdrawals of as high as :750
million a day, nearly 0.5 percent of the entire :170 billion deposit base in the
Greek banking system.
Problems in the Greek banking system then spread to other European nations
with fiscal problems, such as Portugal, Spain, and Italy. The risk of a full-blown
banking crisis arose in Spain, where the debt rating of 16 banks and four regions
were downgraded by Moody’s Investors Service. Throughout Europe, some of
the biggest banks announced billions of euros lost from write-downs on Greek
loans. In 2011, Crédit Agricole reported a record quarterly net loss of :3.07 billion
($4.06 billion U.S.) after a :220 million charge on its Greek debt. Great Britain’s
Royal Bank of Scotland revalued its Greek bonds at a 79 percent loss—or £1.1
billion ($1.7 billion U.S.)—for 2011. Germany’s Commerzbank’s fourth-quarter
2011 earnings decreased by :700 million due to losses on Greek sovereign debt.
The bank needed to find :5.3 billion to meet the stricter new capital requirements
set by Europe’s banking regulator. Bailed-out Franco-Belgian bank Dexia warned
it risked going out of business due to losses of :11.6 billion from its break-up
and exposure to Greek debt and other toxic assets such as U.S. mortgage-backed
securities. Even U.S. banks were affected by the European crisis. In late 2010, U.S.
banks had sovereign risk exposure to Greece totaling $43.1 billion. In addition,
exposures to Ireland totaled $113.9 billion, to Portugal totaled $47.1 billion, and
to Spain totaled $187.5 billion. Worldwide, bank exposure to these four countries
totaled $2,512.3 billion. Default by a small country like Greece cascaded into something that threatened the world’s financial system.
Worried about the effect a Greek debt crisis might have on the European
Union, other European countries tried to step in and assist Greece. On May 9,
2010, in return for huge budget cuts, Europe’s finance ministers and the International Monetary Fund approved a rescue package worth $147 billion and a
“safety net” of $1 trillion aimed at ensuring financial stability across Europe.
Through the rest of 2010 and into 2012, eurozone leaders agreed on more measures designed to prevent the collapse of Greece and other member economies.
In return, Greece continued to offer additional austerity reforms and agreed to
reduce its budget deficits. At times, the extent of these reforms and budget cuts
led to worker strikes and protests (some of which turned violent), as well as
changes in Greek political leadership. In December 2011, the leaders of France
and Germany agreed on a new fiscal pact that they said would help prevent
another debt crisis. French President Nicolas Sarkozy outlined the basic elements
of the plan to increase budget discipline after meeting with German Chancellor
Angela Merkel in Paris. The pact, which involved amending or rewriting the
treaties that govern the European Union, was presented in detail at a meeting
of European leaders and approved. Efforts by the EU and reforms enacted by
the Greek and other European country governments appear to have worked. As
of December 18, 2012, Standard & Poor’s raised its rating on Greek debt by six
notches to B minus from selective default. S&P cited a strong and clear commitment from members of the eurozone to keep Greece in the common currency bloc
as the main reason for the upgrade.
Financial Services: Depository Institutions
63
Summary
This chapter provided an overview of the major activities of commercial banks,
savings institutions, and credit unions. It also described the agencies that regulate
these depository institutions. The Federal Reserve System, the FDIC, the OTS, and
the Office of the Comptroller of the Currency, in conjunction with state regulators,
are the agencies that oversee the activities of these institutions. Each of these institutions relies heavily on deposits to fund its activities, although borrowed funds
are becoming increasingly important for the largest institutions. Historically,
commercial banks have concentrated on commercial or business lending and on
investing in securities, while savings institutions have concentrated on mortgage
lending and credit unions have concentrated on consumer lending. These differences are being eroded as a result of competitive forces, regulation, and changing
financial and business technology.
Questions
and Problems
1. What are the differences between community banks, regional banks, and
money center banks? Contrast the business activities, location, and markets of
each of these bank groups.
2. Use the data in Table 2–5 for banks in the two asset size groups (a)
$100 million–$1 billion and (b) more than $10 billion to answer the following
questions.
a. Why have the ratios for ROA and ROE tended to increase for both groups
over the 1990–2006 period, decrease in 2007–2009, and increase in 2010–2012?
Identify and discuss the primary variables that affect ROA and ROE as they
relate to these two size groups.
b. Why is ROA for the smaller banks generally larger than ROA for the large
banks?
c. Why is the ratio for ROE consistently larger for the large bank group?
d. Using the information on ROE decomposition in Appendix 2A, calculate the
ratio of equity to total assets for each of the two bank groups for the period
1990–2012. Why has there been such dramatic change in the values over this
time period, and why is there a difference in the size of the ratio for the two
groups?
3. What factors caused the decrease in loan volume relative to other assets on the
balance sheets of commercial banks? How has each of these factors been related
to the change and development of the financial services industry during the
1990s and 2000s? What strategic changes have banks implemented to deal with
changes in the financial services environment?
4. What are the major uses of funds for commercial banks in the United States?
What are the primary risks to a bank caused by each of these? Which of the
risks is most critical to the continuing operation of a bank?
5. What are the major sources of funds for commercial banks in the United States?
How is the landscape for these funds changing and why?
6. What are the three major segments of deposit funding? How are these segments
changing over time? Why? What strategic impact do these changes have on the
profitable operation of a bank?
7. How does the liability maturity structure of a bank’s balance sheet compare
with the maturity structure of the asset portfolio? What risks are created or
intensified by these differences?
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Chapter 2
64
Part One
Introduction
8. The following balance sheet accounts (in millions of dollars) have been taken
from the annual report for a U.S. bank. Arrange the accounts in balance sheet
order and determine the value of total assets. Based on the balance sheet
structure, would you classify this bank as a community bank, regional bank,
or money center bank?
Premises
Savings deposits
Cash
NOW accounts
Long-term debt
Other assets
Intangible assets
www.mhhe.com/saunders8e
Other time deposits
$ 1,078
3,292
2,660
12,816
1,191
1,633
758
2,333
Net loans
Short-term borrowing
Other liabilities
Equity
Investment securities
Demand deposits
Certificates of deposit
(under $100,000)
Federal funds sold
$29,981
2,080
778
3,272
5,334
5,939
9,853
110
9. What types of activities are normally classified as off-balance-sheet (OBS)
activities?
a. How does an OBS activity move onto the balance sheet as an asset or
liability?
b. What are the benefits of OBS activities to a bank?
c. What are the risks of OBS activities to a bank?
10. Use the data in Table 2–7 to answer the following questions.
a. What was the average annual growth rate in OBS total commitments over
the period 1992–2012?
b. What categories of contingencies have had the highest annual growth rates?
c. What factors are credited for the significant growth in derivative securities
activities by banks?
11. For each of the following banking organizations, identify which regulatory
agencies (OCC, FRB, FDIC, or state banking commission) may have some regulatory supervision responsibility:
a. State-chartered, nonmember non–holding company bank.
b. State-chartered, nonmember holding company bank.
c. State-chartered member bank.
d. Nationally chartered non–holding company bank.
e. Nationally chartered holding company bank.
12. What are the main features of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994? What major impact on commercial banking activity
occured from this legislation?
13. What factors normally are given credit for the revitalization of the banking
industry during the 1990s? How is Internet banking expected to provide benefits in the future?
14. What factors are given credit for the strong performance of commercial banks
in the early and mid-2000s?
15. What factors are given credit for the weak performance of commercial banks
in the late 2000s?
16. How do the asset and liability structures of a savings institution compare
with the asset and liability structures of a commercial bank? How do these
structural differences affect the risks and operating performance of a savings
institution? What is the QTL test?
Chapter 2
Financial Services: Depository Institutions
65
17. How do savings banks differ from savings associations? Differentiate in
terms of risk, operating performance, balance sheet structure, and regulatory
responsibility.
18. What happened in 1979 to cause the failure of many savings institutions during the early 1980s? What was the effect of this change on the operating statements of savings institutions?
19. How did two pieces of regulatory legislation—the DIDMCA in 1980 and the
DIA in 1982—change the operating profitability of savings institutions in the
early 1980s? What impact did these pieces of legislation ultimately have on
the risk posture of the savings institutions industry? How did the FSLIC react
to this change in operating performance and risk?
20. How did the Financial Institutions Reform, Recovery, and Enforcement Act
(FIRREA) of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991 reverse some of the key features of earlier legislation?
21. What is the “common bond” membership qualification under which credit
unions have been formed and operated? How does this qualification affect the
operational objective of a credit union?
22. What are the operating advantages of credit unions that have caused concern
among commercial bankers? What has been the response of the Credit Union
National Association to the banks’ criticism?
23. How does the asset structure of credit unions compare with the asset structure
of commercial banks and savings institutions? Refer to Tables 2–6, 2–10, and
2–13 to formulate your answer.
24. Compare and contrast the performance of worldwide depository institutions
during and after the financial crisis.
The questions and problems that follow refer to Appendix 2B.
25. The financial statements for First National Bank (FNB) are shown below:
Assets
Cash
Demand deposits from other FIs
Investments
Federal funds sold
Loans
Reserve for loan losses
Premises
Total assets
$
450
1,350
4,050
2,025
15,525
(1,125)
1,685
$23,960
Liabilities and Equity
Demand deposits
Small time deposits
Jumbo CDs
Federal funds purchased
Equity
$ 5,510
10,800
3,200
2,250
2,200
Total liabilities/equity
$23,960
_______
Income Statement - First National Bank
Interest Income
Interest expense
Provision for loan losses
Noninterest income
Noninterest expense
Taxes
$2,600
1,650
180
140
420
90
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Balance Sheet - First National Bank
66
Part One
Introduction
a. Calculate the dollar value of FNB’s earning assets.
b. Calculate FNB’s ROA.
c. Calculate FNB’s asset utilization ratio.
d. Calculate FNB’s spread.
26. Megalopolis Bank has the following balance sheet and income statement.
Balance Sheet (in millions)
Assets
Cash and due from banks
Investment securities
Repurchase agreements
Loans
Fixed Assets
Other assets
Total assets
$
9,000
23,000
42,000
90,000
15,000
4,000
$183,000
Liabilities and Equity
Demand deposits
NOW accounts
Retail CDs
Debentures
Total liabilities
Common stock
Paid in capital
Retained earnings
Total liabilities and equity
Income Statement
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Interest on fees and loans
Interest on investment securities
Interest on repurchase agreements
Interest on deposits in banks
Total interest income
Interest on deposits
Interest on debentures
Total interest expense
Operating income
Provision for loan losses
Other income
Other expenses
Income before taxes
Taxes
Net income
For Megalopolis, calculate:
a.
b.
c.
d.
e.
f.
g.
h.
i.
Return on equity
Return on assets
Asset utilization
Equity multiplier
Profit margin
Interest expense ratio
Provision for loan loss ratio
Noninterest expense ratio
Tax ratio
$ 9,000
4,000
6,000
1,000
$20,000
9,000
2,000
$11,000
$ 9,000
2,000
2,000
1,000
$ 8,000
3,000
$ 5,000
$ 19,000
89,000
28,000
19,000
$155,000
12,000
4,000
12,000
$183,000
Chapter 2
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67
Web Questions
27. Go to the FDIC website at www.fdic.gov and find the most recent breakdown of U.S. bank asset concentrations using the following steps. Click on
“Analysts.” From there click On “FDIC Quarterly Banking Profile” and then
click on “Quarterly Banking Profile.” Click on “Commercial Bank Section.”
Then click on “TABLE III-A. Full Year (or First XXX Quarters) 20XX, FDICInsured Commercial Banks.” This will bring the files up on your computer
that contain the relevant data. How have the number and dollar value of
assets held by commercial banks changed since 2012?
28. Go to the Federal Deposit Insurance Corporation website at www.fdic.gov and
find the latest balance sheet information available for savings institutions using
the following steps. Click on “Analysts.” Click on “Statistics on Banking.” Select
“Savings Institutions,” then click on “Run Report.” This will download a file on
to your computer that will contain the most recent balance sheet information
for savings institutions. Using information in this file, update Table 2–10. How
have the assets and liabilities of credit unions changed since 2012?
29. Go to the National Credit Union Administration website at www.ncua.gov to
collect the most recent information on number of credit unions, assets of credit
unions, and membership in credit unions using the following steps. Click on
“Regulations, Publications and Reports.” Under “Reports, Plans, & Presentations,” click on “Industry At a Glance (IAG).” Click on the most recent date.
This will download a file onto your computer that will contain the necessary
data. How have these data changed since 2012?
Appendix 2A: Financial Statement Analysis Using a Return on
Equity (ROE) Framework
View Appendix 2A at the website for this textbook (www.mhhe.com/saunders8e).
View Appendix 2B at the website for this textbook (www.mhhe.com/saunders8e).
Appendix 2C: Depository Institutions and Their Regulators
View Appendix 2C at the website for this textbook (www.mhhe.com/saunders8e).
Appendix 2D: Technology in Commercial Banking
View Appendix 2D at the website for this textbook (www.mhhe.com/saunders8e).
www.mhhe.com/saunders8e
Appendix 2B: Commercial Banks’ Financial Statements and
Analysis
Chapter Three
Financial Services:
Finance Companies
INTRODUCTION
Like commercial banks, savings institutions, and credit unions, the main financial
service provided by finance companies is lending. That is, the primary function of
finance companies is to make loans to both individuals and corporations. The services provided by finance companies include consumer lending, business lending,
and mortgage financing. Some of their loans are similar to depository institutions
loans, such as consumer and auto loans, but others are more specialized. Finance
companies differ from depository institutions in that they do not accept deposits
but instead rely on short- and long-term debt as a source of funds. Additionally,
finance companies often lend to customers depository institutions find too risky.
This difference can lead to losses and even failure if the high risk does not pay off.
In this chapter we look at the services provided by finance companies and the
competitive and financial situation facing these firms. We discuss the size, structure, and composition of the industry; the services the industry provides; its competitive and financial position; and its regulation. We conclude the chapter with
a look at some global issues. From this chapter, the reader should obtain a basic
understanding of services provided by finance companies, their performance, and
the degree to which they are regulated.
SIZE, STRUCTURE, AND COMPOSITION OF THE INDUSTRY
www.gecapital.com
68
The first major finance company was originated during the Depression, when
General Electric Corp. created General Electric Capital Corp. (GECC) as a means
of financing appliance sales to cash-constrained customers who were unable to
get installment credit from banks. Installment credit is a loan that is paid back to
the lender with periodic payments (installments) consisting of varying amounts
of interest and principal (e.g., auto loans, home mortgages, and student loans). By
the late 1950s banks were more willing to make installment loans, and so finance
companies began looking outside their parent companies for business. GE Capital’s consumer finance and banking businesses today provides millions of customers with loans, including credit card, personal, auto financing, and real estate
loans. GE Capital Real Estate’s assets total $73 billion, while GE Energy Financial
Chapter 3
www.ally.com
Financial Services: Finance Companies
69
Services’ assets total $21 billion. GECC also now performs commercial lending
and leasing in a number of industries, from aviation, health care, and energy
financing, to fleet, franchise, and middle market corporate finance. In the United
States, Canada, and Mexico, GE Capital is a leading provider of business lending
and leasing for companies of all sizes in a wide array of industries. In Europe, GE
Capital has more than 350,000 customers, while in Asia, GE Capital provides services for more than 15 million businesses and consumers. Services include acquisition finance, inventory and working capital financing, leveraged and sponsor
finance, equity capital, equipment leasing, and fleet management. GE Aviation is
a world-leading provider of commercial and military jet engines and components.
GE Aviation owns and manages more than 1,800 aircraft, for more than 245 customers in 75 countries.1
GE Capital’s exposure to the financial crisis resulted in General Electric Corp.’s market value falling by more than half during 2008 (GE Capital accounted for about half
of GE’s sales and profit). The parent company’s stock price fell to $14.58 in November
2008, its lowest level since January 1997. In order to reassure investors and help GE
Capital unit compete with banks that already had government protection behind their
debt, on November 12, 2008, the FDIC approved GE Capital’s application for designation as an eligible entity under the FDIC’s Temporary Liquidity Guarantee Program
(TLGP). Under the TLGP, as much as $139 billion in debt (or 125 percent of total senior
unsecured debt outstanding as of September 30, 2008) issued by GE Capital was
guaranteed and backed by the full faith and credit of the United States. Granting this
finance company access to the FDIC program was possible because GE Capital also
owns a federal savings bank and an industrial loan company, both of which qualified
for FDIC assistance. The terms of these agreements included, among other things, a
requirement that GE and GE Capital reimburse the FDIC for any amounts that the
FDIC paid to holders of debt that was guaranteed by the FDIC. In July 2009, GE Capital received approval to exit the TLGP program.
Ally Financial (formerly GMAC) is another major finance company, founded in
1919 as the General Motors Acceptance Corporation (GMAC), a provider of financing to automotive customers. Since then, the business has expanded to include insurance, direct banking, mortgage operations, and commercial finance. In November
2006, General Motors sold a 51 percent interest in GMAC to a consortium of investors led by hedge fund Cerberus Capital Management and subsidiaries of Citigroup,
Aozora Bank, and PNC Financial. GMAC’s existing management team remained in
place, but the finance company assumed a separate and independent credit profile
and independent governance by a new board of directors. Under terms of the transaction, General Motors and GMAC entered into a 10-year agreement under which
GMAC remained the exclusive provider of GM-sponsored auto finance programs.
December 24, 2008, was a key turning point in GMAC’s history when it was
approved as a bank holding company by the Federal Reserve Board under the Bank
Holding Company Act. GMAC had been hit with huge losses in both its mortgage
and auto loan businesses. Its mortgage unit, Residential Capital, had suffered significant losses on home loans it made during the housing boom of the early and
mid-2000s. The company lost $8 billion in 2007–2008. In light of the impact GMAC’s
losses were having on financial markets, to help ensure the survival of the company, federal regulators permitted the financing arm of General Motors to become
a bank holding company. The move allowed GMAC access to as much as $6 billion
1
See GECC’s website, www.gecapital.com.
70
Part One
Introduction
TABLE 3–1
Assets and
Liabilities of U.S.
Finance Companies,
2012
Source: Federal Reserve
Board, December 2012.
www.federalreserve.gov
Billions
of Dollars
Percent
of Total Assets
Assets
Accounts receivable gross
Consumer
Business
Real estate
Less reserves for unearned income
Less reserves for losses
Accounts receivable net
All other
Total assets
$1,300.8
578.3
429.2
293.3
(24.3)
(26.5)
74.8%
33.3
24.7
16.8
(1.4)
(1.5)
$1,250.0
488.0
$1,738.0
71.9%
28.1
100.0%
$76.5
61.8
256.6
771.5
322.4
249.2
$1,738.0
4.4%
3.6
14.8
44.4
18.5
14.3
100.0%
Liabilities and Capital
Bank loans
Commercial paper
Debt due to parent
Debt not elsewhere classified
All other liabilities
Capital, surplus, and undivided profits
Total liabilities and capital
in government bailout money. As part of the deal, Cerberus Capital Management
was forced to cut its stake in the new bank holding company to less than 15 percent and become a passive investor. Cerberus also stopped providing consulting
services to GMAC and the two entities would no longer share executives. Also as a
condition of the Federal Reserve’s approval, General Motors had to reduce its ownership stake in GMAC to less than 10 percent, from 49 percent. As of November
2012, the U.S. Treasury owned 73.8 percent of GMAC, followed by General Motors
(9.9 percent), Cerberus (8.7 percent), and other third-party investors (7.6 percent).
The Federal Reserve’s decision to approve GMAC’s application was particularly controversial. Critics had raised questions about GMAC’s financial strength,
its ownership by a private equity firm, and whether it was involved in too many
commercial activities to become a bank. GMAC had to make several changes to its
structure to alleviate concerns. The Fed, which had been considering the proposal
since early November, determined that “emergency conditions” made it imperative that it act quickly. Regulators also wanted to approve GMAC’s application
to become a bank so that it could apply for federal funds before a year-end deadline set by the Treasury Department. The company would also be subject to more
stringent federal oversight and had to diversify its business beyond loans to car
buyers and dealerships. Despite these changes, GMAC still operates and provides
financial services mainly as a finance company.
Because of the attractive rates they offer on some loans (such as new car loans,
see below), their willingness to lend to riskier borrowers than depository institutions, their often direct affiliation with manufacturing firms, and the relatively
limited amount of regulation imposed on these firms, finance companies have
been among the fastest growing FI groups in recent years. In 2012 their assets
stood at $1,738.0 billion (see Table 3–1). Comparing this to assets at the end of 1977
(reported in Table 3–2) of $104.3 billion, this industry has experienced growth of
almost 1,566 percent in the last 35 years.
Chapter 3
TABLE 3–2
Assets and
Liabilities of U.S.
Finance Companies
on December 31,
1977
Source: Federal Reserve Bulletin, June 1978, p. A39.
www.federalreserve.gov
www.fordcredit.com
www.hfc.com
www.aigag.com
Financial Services: Finance Companies
Billions
of Dollars
Assets
Accounts receivable gross
Consumer
Business
Less reserves for unearned income and losses
Accounts receivable net
Cash and bank deposit
Securities
All other
$ 99.2
44.0
55.2
(12.7)
71
Percent
of Total Assets
95.1%
42.2
52.9
(12.2)
$ 86.5
2.6
0.9
14.3
82.9%
2.5
0.9
13.7
Total assets
Liabilities and Capital
Bank loans
Commercial paper
Debt
Short-term
Long-term
Other
Capital, surplus, and undivided profits
$104.3
100.0%
Total liabilities and capital
$104.3
$
5.9
29.6
5.7%
28.4
6.2
36.0
11.5
15.1
5.9
34.5
11.0
14.5
100.0%
www.cit.com
sales finance
institutions
Institutions that
specialize in making
loans to the customers
of a particular retailer
or manufacturer.
personal credit
institutions
Institutions that
specialize in making
installment and other
loans to consumers.
business credit
institutions
Institutions that
specialize in making
business loans.
factoring
The process of
purchasing accounts
receivable from
corporations (often at
a discount), usually
with no recourse to the
seller if the receivables
go bad.
The three major types of finance companies are (1) sales finance institutions,
(2) personal credit institutions, and (3) business credit institutions. Sales finance
institutions (e.g., Ford Motor Credit and Sears Roebuck Acceptance Corp.) specialize in making loans to the customers of a particular retailer or manufacturer.
Because sales finance institutions can frequently process loans faster and more
conveniently (generally at the location of purchase) than depository institutions,
this sector of the industry competes directly with depository institutions for consumer loans. Personal credit institutions (e.g., HSBC Finance and AIG American
General) specialize in making installment and other loans to consumers. Personal
credit institutions will make loans to customers that depository institutions find
too risky to lend to (due to low income or a bad credit history). These institutions
compensate for the additional risk by charging higher interest rates than depository institutions and/or accepting collateral (e.g., used cars) that depository institutions do not find acceptable. Business credit institutions (e.g., CIT Group and
U.S. Bancorp Equipment Finance) are companies that provide financing to corporations, especially through equipment leasing and factoring, in which the finance
company purchases accounts receivable from corporate customers. These accounts
are purchased at a discount from their face value, and the finance company specializes in and assumes the responsibility for collecting the accounts receivable. As
a result, the corporate customer no longer has the worry of whether the accounts
receivable may or may not be delayed and thus receives cash for sales faster than
the time it takes customers to pay their bills. Many finance companies perform
more than one of these three services (e.g., GMAC).
The industry is quite concentrated, with the largest 20 firms accounting for
more than 65 percent of its assets. In addition, many of the largest finance companies, such as Ford Motor Credit Corp., tend to be wholly owned or captive
72
Part One
TABLE 3–3
Introduction
The Largest Finance Companies
Sources: Insurance Information Institute and authors’ research.
Total
Receivables
($ millions)
Company Name
General Electric Capital Corporation
Capital One Financial
203,132
Sales finance and
business credit
Personal credit
SLM Corp.
J.P. Morgan Chase (credit card business)
Ally Financial
167,166
124,537
121,259
Personal credit
Personal credit
Sales finance
American Express
117,380
Personal credit
Citigroup (credit card business)
Bank of America (credit card business)
HSBC Finance Corp.
Ford Motor Credit Company
108,819
108,659
86,680
71,517
Personal credit
Personal credit
Personal credit
Sales finance
captive finance
company
A finance company that is wholly
owned by a parent
corporation.
Concept
Questions
$285,395
Type of Finance
Company
Ownership
Captive of GE
NYSE-listed independent that
also owns Capital One Bank
NYSE-listed independent
Part of J.P. Morgan Chase
Owned by consortium of
investors including the
U.S. Treasury, Cerberus Capital
Management, and GM
NYSE-listed independent that also
owns American Express Bank
Part of Citigroup
Part of Bank of America
Subsidiary of HSBC Holdings
Captive of Ford
subsidiaries of major manufacturing companies. A major role of a captive finance
company is to provide financing for the purchase of products manufactured by
the parent, as Ford Motor Credit Corp. does for cars. In turn, the parent company
is often a major source of debt finance for the captive finance company. A benefit
of the captive finance subsidiary to the parent company is diversification in revenue streams. For example, as the auto industry suffered from a lack of sales in
the mid-2000s, Ford Motor Credit Corp. was producing record profits, as much as
80 percent of the overall profits of Ford Motor Corporation.
Table 3–3 lists some of the top finance companies (in terms of total receivables)
as of 2012. GECC is the largest with receivables totaling $285.4 billion. Note that 6
of the 10 finance companies are subsidiaries of financial services holding companies such as Citigroup. Thus, while Citibank cannot make high-risk, high-interest
rate loans due to bank regulations that restrict credit risk, Citigroup can indirectly
make these loans through its finance company subsidiary.
1. What are the three major types of finance companies? What types of customers does
each serve?
2. What is a captive finance company?
BALANCE SHEET AND RECENT TRENDS
Assets
As mentioned earlier, finance companies provide three basic lending services:
customer lending, consumer lending, and business lending. In Table 3–1 we
show the balance sheet of finance companies in 2012. As you can see, business
and consumer loans (called accounts receivable) are major assets held by finance
Chapter 3
Financial Services: Finance Companies
73
companies, accounting for 58.0 percent of total assets, while real estate loans
are 16.8 percent of total assets. Comparing the figures in Table 3–1 to those in
Table 3–2 for 1977, we see that 95.1 percent of total assets were consumer and
business loans in 1977, yet no real estate loans were listed. Over the last 35 years,
finance companies have replaced consumer and business loans with increasing amounts of real estate loans and other assets, although these loans have
not become dominant, as is the case with depository institutions. However, like
depository institutions, these activities create credit risk, interest rate risk, and
liquidity risk that finance company managers must evaluate and manage. The
financial crisis was a period that saw the downside of these risks, producing
losses in all lending areas for the industry.
Table 3–4 shows the breakdown of the industry’s loans in 1995 and 2012 for
consumer, real estate, and business lending. In recent years, the fastest-growing
areas of asset business have been in the nonconsumer finance areas, especially
leasing and business lending. In 2012, consumer loans constituted 58.5 percent
of all finance company loans, mortgages represented 12.8 percent, and business
loans comprised 28.7 percent.
Consumer Loans
subprime lender
A finance company
that lends to high-risk
customers.
Consumer loans consist of motor vehicle loans and leases, other consumer loans,
and securitized loans from each category. Motor vehicle loans and leases are traditionally the major type of consumer loan (53.1 percent of the consumer loan
portfolio in 2012). As can be seen from Table 3–5, finance companies historically
charged higher rates for automobile loans than did commercial banks. In 1995 and
1996, auto finance companies charged interest rates 1.62 and 0.79 percent, respectively, higher than those of commercial banks. Nevertheless, sometimes these rates
get lowered dramatically. For example, because new car sales by U.S. firms in the
late 1990s were lower than normal, auto finance companies owned by the major
auto manufacturers slashed interest rates on new car loans (some to as low as
0.9 percent). Moreover, after the terrorist attacks in September 2001, the major auto
manufacturers lowered rates on many new car loans to 0 percent in an attempt
to boost sales. Some of these 0 percent rates continued to be offered into 2005
as the U.S. economy struggled to recover and the general level of interest rates
remained low. The financial crisis saw the resurrection of 0 percent car loan rates
as auto manufacturers tried to boost slumping car sales. Notice that the difference
between new car loans at commercial banks and finance companies continued to
widen throughout the early 2000s. By 2002 finance companies were charging more
than 3.3 percent less on new car loans than commercial banks, mainly due to the
zero interest rates offered by the major auto manufacturers’ captive finance company loans to new car buyers. However, other than for new car loans, these types
of low rates are fairly rare.
The higher rates finance companies charge for consumer loans are mostly
due to the fact that finance companies attract riskier customers than commercial
banks. Customers who seek individual (or business) loans from finance companies are often those judged too risky to obtain loans from commercial banks or
thrifts.2 It is, in fact, possible for individuals to get a loan from a subprime lender
finance company (a finance company that lends to high-risk customers) even with
2
We look at the analysis of borrower (credit) risk in Chapter 10.
74
Part One
Introduction
TABLE 3–4
Finance Company
Loans Outstanding,
1995–2012 (in
billions of dollars)
Consumer
Source: Federal Reserve
Board, “Flow of Fund
Accounts,” various issues.
www.federalreserve.gov
1995
Percent of
Total, 1995
2012
Percent of
Total, 2012
$285.8
$ 41.5%
$ 839.4
58.5%
Motor vehicle loans
81.1
11.8
294.6
20.5
Motor vehicle leases
80.8
11.7
139.9
9.7
Revolving1
28.5
4.1
74.2
5.2
42.6
6.2
312.2
21.8
2
Other
Securitized assets
Motor vehicle loans
34.8
5.1
11.0
0.8
Motor vehicle leases
3.5
0.5
0.0
0.0
Revolving
n.a.
n.a.
0.0
0.0
Other
14.7
Real estate
$ 72.4
2.1
10.5%
7.4
$ 183.5
0.5
12.8%
One- to four-family
n.a.
n.a.
134.0
9.3
Other
n.a.
n.a.
49.9
3.5
n.a.
n.a.
0.0
0.0
Securitized real estate assets3
One- to four-family
Other
Business
Motor vehicles
n.a.
$331.2
n.a.
48.0%
0.1
$ 411.8
0.0
28.7%
66.5
9.6
127.5
8.9
Retail loans
21.8
3.1
23.7
1.7
Wholesale loans4
36.6
5.3
73.0
5.1
Leases
Equipment
8.0
1.2
30.8
2.1
188.0
27.3
202.6
14.1
8.4
Loans
58.6
8.5
120.6
Leases
129.4
18.8
82.0
5.7
47.2
6.8
81.7
5.7
20.6
3.0
0.0
0.0
1.8
0.3
0.0
0.0
18.8
2.7
0.0
0.0
Other business receivables5
Securitized assets3
Motor vehicles
Retail loans
Wholesale loans
Equipment
8.1
1.2
0.0
0.0
Loans
5.3
0.8
0.0
0.0
Leases
2.8
0.4
0.0
0.0
0.8
0.1
0.0
Other business receivables5
Total
1
$689.5
$100.0%
$1,434.7
0.0
100.0%
Excludes revolving credit reported as held by depository institutions that are subsidiaries of finance companies.
Includes personal cash loans, mobile home loans, and loans to purchase other types of consumer goods, such as appliances,
apparel, boats, and recreation vehicles.
3
Outstanding balances of pools on which securities have been issued; these balances are no longer carried on the balance
sheets of the loan originator.
4
Credit arising from transactions between manufacturers and dealers, that is, floor plan financing.
5
Includes loans on commercial accounts receivable, factored commercial accounts, and receivable dealer capital; small loans
used primarily for business or farm purposes; and wholesale and lease paper for mobile homes, campers, and travel trailers.
2
Chapter 3
TABLE 3–5
Financial Services: Finance Companies
75
Consumer Credit Interest Rates, 1995–2012
Source: Federal Reserve Board, “Flow of Fund Accounts,” various dates. www.federalreserve.gov
Type
Commercial bank new car
Auto finance company new car
Difference in commercial bank
versus finance company rate
loan sharks
Subprime lenders
that charge unfairly
exorbitant rates to
desperate subprime
borrowers.
1995
1996
9.57%
11.19
9.05%
9.84
1.62
0.79
1997
2002
2007
2008
2012
9.02%
7.12
7.62%
4.29
7.77%
4.87
7.02%
5.52
5.73%
4.73
⫺1.90
⫺3.33
⫺2.90
⫺1.50
⫺1.00
a bankruptcy on their records. For example, Jayhawk Acceptance Corp., one of
a group of finance companies that lent money to used-car buyers with poor or
no credit, began marketing loans for tummy tucks, hair transplants, and other
procedures that are not usually covered by health insurance. Jayhawk entered
into contracts with doctors to lend money to their patients who were seeking cosmetic surgery or some types of dental procedures. Borrowers who paid the loans
within a year paid an annual rate of 9.9 percent, while those who repaid within
the maximum of two years paid 13.9 percent per year. Left unanswered, however,
was what Jayhawk could repossess if a borrower defaulted on a loan. Jayhawk
eventually declared bankruptcy. Banks would rarely make these types of risky
loans. Most finance companies that offer these types of loans charge rates commensurate with the higher risk, and there are a few loan shark companies that
prey on desperate consumers, charging exorbitant rates as high as 30 percent per
year or more.
Another case of a subprime lender is the payday lender. Payday lenders provide short-term cash advances that are often due when borrowers receive their
next paycheck. The payday lending industry originated from check cashing outlets in the early 1990s and has exploded in recent years as demand for short-term
loans has risen. A typical borrower takes out a two-week loan and pays $15 for
every $100 borrowed, or the equivalent of a 390 percent annual interest rate. The
typical customer earns between $25,000 and $50,000 per year. Payday lenders generate approximately $44 billion in loans annually and earned about $10 billion
in revenue in 2012. The number of storefronts more than doubled between 2000
and 2012, to roughly 24,000 nationwide and hundreds of websites. As of September 2012, payday lender Cash America International had $256.8 million in payday
loans on its balance sheet and charged $558.7 million in interest and fees. Critics
claim that rates are exorbitant and often trap financially strapped borrowers in a
cycle of paying additional fees to renew the same amount of principal. Lenders
argue that the high rates are necessary to cover costs, offset higher default rates,
and still earn a profit.
The payday loan industry is regulated at the state level. As of 2012, 18 states
had effectively banned payday lending. When not explicitly banned, laws that
prohibit payday lending are usually in the form of usury limits. Payday lenders
have succeeded in getting around usury laws in some states by forming relationships with nationally chartered banks based in a different state with no usury ceiling (such as South Dakota or Delaware). As federal banking regulators became
aware of this practice, they began prohibiting these partnerships between commercial banks and payday lenders. The FDIC still allows its member banks to
participate in payday lending, but it did issue guidelines in March 2005 that are
76
Part One
Introduction
meant to discourage long-term debt cycles by transitioning to a longer-term loan
after six payday loan renewals.
Revolving and other consumer loans include personal cash loans, mobile home
loans, and private-label credit card loans (e.g., Discover card) to purchase other
types of consumer goods, such as appliances, apparel, general merchandise, and
recreational vehicles. In 2012, these loans made up 46.9 percent of the consumer
loan portfolio of finance companies.
Mortgages
securitized
mortgage assets
Mortgages packaged
and used as assets
backing secondary
market securities.
home equity loans
Loans that let
customers borrow
on a line of credit
secured with a second
mortgage on their
home.
Residential and commercial mortgages have become a major component in
finance company portfolios, although, referring again to Table 3–2, they did not
generally deal in mortgages in 1977. However, since finance companies are not
subject to as extensive regulations as are banks, they are often willing to issue
mortgages to riskier borrowers than commercial banks. They compensate for this
additional risk by charging higher interest rates and fees. Mortgages include all
loans secured by liens on any type of real estate. Mortgages can be made either
directly or as securitized mortgage assets. Securitization of mortgages involves
the pooling of a group of mortgages with similar characteristics, the removal of
these mortgages from the balance sheet, and the subsequent sale of interests in the
pool to secondary market investors. Securitization of mortgages results in the
creation of mortgage-backed securities (e.g., government agency securities, collateralized mortgage obligations), which can be traded in secondary mortgage
markets.3 While removed from its balance sheet, the finance company that originates the mortgage may still service the mortgage portfolio for a fee.4
The mortgages in the loan portfolio can be first mortgages or second mortgages
in the form of home equity loans. Home equity loans allow customers to borrow
on a line of credit secured with a second mortgage on their home. Home equity
loans have become very profitable for finance companies since the Tax Reform
Act of 1986 was passed, disallowing the tax deductibility of consumers’ interest
payments other than those on home mortgages. Specifically, interest on (first and
second) mortgages secured by residential real estate is tax deductible. Interest on
other types of individual loans—such as consumer (e.g., credit card) loans—is not
eligible for a tax deduction. Also, the bad debt expense and administrative costs
on home equity loans are lower than those on other finance company loans. As
discussed below, in 2007–2008 a sharp rise in late payments and defaults by subprime and even relatively strong credit mortgage and home equity loan borrowers
caused large losses for mortgage lenders and mortgage-backed securities investors, and ultimately was the root cause of the financial crisis of 2008–2009.
Business Loans
Business loans represent 28.7 percent of the loan portfolio of finance companies.
Finance companies have several advantages over commercial banks in offering services to small business customers. First, as mentioned earlier, they are not subject
to regulations that restrict the types of products and services they can offer. Second,
3
We discuss the securitization of mortgages in more detail in Chapter 26.
Mortgage servicing is a fee-related business whereby, after mortgages are securitized, the flow of
mortgage repayments (interest and principal) has to be collected and passed on (by the mortgage servicer) to investors in either whole mortgage loan packages or securitization vehicles such as pass-through
securities (see Chapter 26). In undertaking this intermediation activity, the servicer charges a fee.
4
Chapter 3
Financial Services: Finance Companies
77
because finance companies do not accept deposits, they have no bank-type regulators looking directly over their shoulders.5 Third, being in many cases subsidiaries
of corporate-sector holding companies, finance companies often have substantial
industry and product expertise. Fourth, as mentioned in regard to consumer loans,
finance companies are more willing to accept risky customers than are commercial
banks. Fifth, finance companies generally have lower overheads than banks have;
for example, they do not need tellers or branches for taking deposits.
The major subcategories of business loans are retail and wholesale motor vehicle loans and leases (31.0 percent of all business loans in 2012), equipment loans
(49.2 percent), other business loans (19.8 percent), and securitized business assets
(0.0 percent). Motor vehicle loans consist of retail loans that assist in transactions
between the retail seller of the product and the ultimate consumer (i.e., passenger
car fleets and commercial land vehicles for which licenses are required). Wholesale
loans are loan agreements between parties other than the companies’ consumers.
For example, Ford Motor Credit Corp. (FMCC) provides wholesale financing to
Ford dealers for inventory floor plans in which FMCC pays for Ford dealers’ auto
inventory received from Ford. FMCC puts a lien on each car on the showroom
floor. While the dealer pays periodic interest on the floor plan loan, it is not until
the car is sold that the dealer pays for the car. These activities extend to retail and
wholesale leasing of motor vehicles as well.
Business-lending activities of finance companies also include equipment loans,
with the finance company either owning or leasing the equipment directly to
its industrial customer or providing the financial backing for a leveraged lease,
a working capital loan, or a loan to purchase or remodel the customer’s facility.
Finance companies often prefer to lease equipment rather than sell and finance
the purchase of equipment. One reason for this is that repossession of the equipment in the event of default is less complicated when the finance company retains
its title (by leasing). Further, a lease agreement generally requires no down payment, making a lease more attractive to the business customer. Finally, when the
finance company retains ownership of the equipment (by leasing), it receives a tax
deduction in the form of depreciation expense on the equipment. Other business
loans include loans to businesses to finance accounts receivable, factored commercial accounts, small farm loans, and wholesale and lease paper for mobile homes,
campers, and trailers.
Liabilities and Equity
To finance asset growth, finance companies have relied primarily on short-term
commercial paper and other debt (longer-term notes and bonds). Thus, management of liquidity risk is quite different from that in commercial banks that mostly
rely on deposits (see Chapter 2). As reported in Table 3–1, in 2012 commercial
paper amounted to $61.8 billion (3.6 percent of total assets), while other debt (debt
due to parents and debt not elsewhere classified) totaled $1,028.1 billion (59.2 percent) and bank loans totaled $76.5 billion (4.4 percent). Debt due to parent includes
all short- and long-term debt owed to the parent company of the finance company,
for example, debt Ford Motor Credit Corp. owes to Ford Motor Corp. Debt not
elsewhere classified includes all short- and long-term debt (loans, notes, certificates, negotiable paper, or other) owed to external lenders not listed above. If the
5
Finance companies do, of course, have market participants looking over their shoulders and monitoring
their activities.
78
Part One
Introduction
finance company subsidiary has a bad year and cannot make promised payments
on its debt, the parent company would be less likely than external fund providers
to initiate legal proceedings against the finance company. However, given their
large percentage of funding, the parent to a finance company is susceptible to
large losses of its own if the finance company subsidiary has a bad year.
Comparing these figures with those for 1977 (in Table 3–2), commercial paper
was used more in 1977 (28.4 percent of total liabilities and capital), while other debt
(short- and long-term) was less significant as a source of financing (40.4 percent).
Finance companies also now rely less heavily on bank loans for financing. In 1977,
bank loans accounted for 5.7 percent of total financing. Much of the change in funding sources is due to the strong economy and low interest rates in the U.S. long-term
debt markets in the early and mid-2000s and the continued low interest rates during the financial crisis of 2008–2009. Finally, in 2012 finance companies’ capital-toassets ratio was 14.3 percent, only slightly lower than the 14.5 percent in 1977.
As discussed earlier, unlike banks and thrifts, finance companies cannot issue
deposits. Rather, to finance assets, finance companies rely heavily on short-term
commercial paper, with many having direct sale programs in which commercial
paper is sold directly to mutual funds and other institutional investors on a continuous day-by-day basis. Indeed, finance companies are now the largest issuers
in the short-term commercial paper market. Most commercial paper issues have
maturities of 30 days or less, although they can be issued with maturities of up to
270 days.6
INDUSTRY PERFORMANCE
www.hfc.com
In the early 2000s, the outlook for the industry as a whole was bright. Interest
rates were at historical lows. Mortgage refinancing grew, and loan demand among
lower- and middle-income consumers was strong. Because many of their potential
borrowers had very low savings, no major slowdown in the demand for finance
company services was expected. The largest finance companies—those that lend
to less risky individual and business customers and with few subprime borrowers
(e.g., HSBC Finance)—experienced strong profits and loan growth. (The industry’s assets as a whole grew at a rate of almost 8 percent in the early 2000s.) As
such, the most successful finance companies became takeover targets for other
financial service as well as industrial firms. For example, Citigroup acquired
Associates First Capital to create the largest full-service financial institution in the
country. In May 2001 American General (the then 13th-largest finance company)
was acquired by American International Group (AIG), one of the country’s largest
life insurance companies. Finally, in 2003 Household International was acquired
by British commercial bank HSBC Holdings for $14.9 billion. This acquisition was
one of the largest M&As of any kind in 2003. These are just other examples of integration and consolidation among firms in the financial services sector.
Nevertheless, in the mid- and late 2000s problems for industry participants who
specialized in loans to relatively lower-quality customers created large losses in
the industry and a very big problem for the U.S. economy as a whole. As home
prices began to fall in 2005 and 2006 and borrowers faced rising interest rates,
6
Commercial paper issued with a maturity longer than 270 days has to be registered with the SEC (i.e., it
is treated the same as publicly placed bonds).
Chapter 3
Financial Services: Finance Companies
79
more people defaulted on their mortgages. At the end of 2006, the percentage
of subprime mortgage loans on which payments were at least 60 days late was
14 percent, up from 6 percent in early 2005. With delinquencies and defaults by
borrowers rising, finance companies started a sharp pullback in subprime lending. Originations of subprime mortgages declined 30 to 35 percent in 2007 from
2006, when they totaled approximately $600 billion, or about one-fifth of the entire
mortgage market. The results were sharply lower values for finance companies.
For example, shares of New Century Financial, the number-two subprime lender,
plunged nearly 79 percent in early March 2007 after the company said it was facing
a criminal probe of its practices by the Justice Department and its outside auditor
said it believed there was substantial doubt about New Century’s ability to continue as a going concern. On March 13, 2007, the NYSE suspended trading on the
company’s stock and began steps to delist the company. Similarly, Fremont General Corp. lost one-third of its value after it announced it would exit the subprime
sector due to demands of regulators and market conditions. Countrywide Financial, the country’s leading mortgage lender, lost over half its market value in the
summer and fall of 2007 as it announced continued losses in its subprime mortgage
portfolio. Only a $2 billion equity investment by Bank of America in 2007 and then
an acquisition offer in 2008 kept this finance company alive. However, in March
2008, the FBI announced a probe of Countrywide for possible securities fraud. The
inquiry focused on whether company officials made misrepresentations about the
company’s financial position and the quality of its mortgage loans in securities filings. Other leaders in the subprime mortgage lending market were units of some
of the nation’s biggest financial services holding companies, including HSBC (the
number-one subprime mortgage lender, which took a $10.6 million charge for bad
loans in 2006), General Electric, Wells Fargo, and Washington Mutual.
This crash in the subprime mortgage market led to serious problems in the U.S.
and worldwide economies. The housing boom of the early 2000s held defaults to
very low levels because borrowers who fell behind on payments could easily sell
their homes or refinance into a loan with easier terms. Further, roughly two-thirds
of mortgages were packaged into securities and sold to investors worldwide. That
and other innovations made credit cheaper and more available, helping more people to afford a home. But as home prices flattened and then dropped in most parts
of the country, more borrowers fell behind on their mortgage payments. By the
end of 2009 mortgage loan delinquencies increased for the 12th straight quarter,
hitting an all-time national average high of 6.89 percent. This rate indicated that
more than 7.2 million mortgage loans were behind on payments. As the financial
crisis developed and spread, other areas of lending saw increased losses. Small
business loan failure rates hit the double digits, at 11.9 percent, in 2009; in 2004,
the failure rate was 2.4 percent. In 2009, the national default rate for commercial
real estate mortgages rose to 2.25 percent from 1.62 percent in the fourth quarter of
2008. This was the largest quarterly increase since at least 1992. Finance company
performance suffered along with these decreases in loan performance.
As noted earlier, the crisis resulted in the failure of Countrywide Financial and
the forced conversion of GMAC Financial Services to a bank holding company in
order to prevent its failure. Another notable failure is that of CIT Group, which
filed for Chapter 11 bankruptcy in November 2009. In 2008, CIT was a lender
to nearly a million mostly small and midsize businesses and companies. As the
financial crisis hit, many of its borrowers became delinquent or defaulted on their
loans. While CIT’s failure would not affect financial markets to the same extent as
80
Part One
Introduction
the failure of a large commercial bank such as Citigroup, it could hurt the flow of
credit to many businesses to which banks traditionally did not lend. As a result,
in December 2008, the Federal Reserve approved CIT Group’s application to convert to a bank holding company, clearing a key hurdle for the firm to bolster its
resources with loans and support from the government’s financial rescue fund.
However, as the financial crisis wore on, losses mounted, and CIT was forced to
file for bankruptcy protection. At the time of bankruptcy, CIT had assets of $71
billion and liabilities of $65 billion. The bankruptcy eliminated $10 billion of this
debt, including $2.3 billion extended to CIT in 2008 as part of the taxpayer bailout
of the finance company. The bankruptcy of CIT Group was one of the largest filings ever of a U.S. company—trailing only the likes of Lehman Brothers, Washington Mutual, and General Motors.
As was true with depository institutions, as the U.S. economy improved in
the late 2000s and early 2010s, the finance company industry improved as well.
Employment in the industry increased from 561,700 in 2010 to 562,400 in 2011 (still
below the 2007 level of 715,900). Further, in 2011, the median ROE for business
credit institutions increased to 9.33 percent from 7.81 percent in 2010. However,
the median ROE for personal credit institutions decreased to 13.73 percent in 2011
from 14.12 percent in 2010. Financial crisis issues remained even into 2012. Industry
assets totaled $1.74 trillion in 2012 down from $1.75 trillion in 2010 and $2.21 trillion
in 2008. Receivables also lagged behind pre-crisis levels. Total receivables dropped
from $1.77 trillion in mid-2008 to $1.40 trillion in 2009 and $1.30 trillion in 2012.
Concept
Questions
1. How have the major assets held by finance companies changed in the last 30 years?
2. How do subprime lender finance company consumer loan customers differ from consumer loan customers at banks?
3. What advantages do finance companies offer over commercial banks to small
business customers?
REGULATION
The Federal Reserve defines a finance company as a firm (other than a depository
institution) whose primary assets are loans to individuals and businesses.7 Finance
companies, like depository institutions, are financial intermediaries that borrow
funds for relending, making a profit on the difference between the interest rate on
borrowed funds and the rate charged on the loans. Also like depository institutions, finance companies are subject to any state-imposed usury ceilings on the
maximum loan rate assigned to any individual customer and are regulated as to
the extent to which they can collect on delinquent loans (e.g., legal mechanisms to
be followed). However, because finance companies do not accept deposits, they are
not subject to extensive oversight by any specific federal or state regulators as are
banks or thrifts—even though they offer services that compete directly with those
of depository institutions (e.g., consumer installment loans and mortgages).8 The
lack of regulatory oversight for these companies enables them to offer a wide scope
of “bank-like” services and yet avoid the expense of regulatory compliance, such
7
8
Whereas a bank is defined as an institution that both accepts deposits and makes loans.
Like any corporation, they are subject to SEC disclosure rules.
Chapter 3
Financial Services: Finance Companies
81
as that imposed on banks and thrifts by the Community Reinvestment Act of 1977,
which requires these institutions to keep and file extensive reports showing that
they are not discriminating in their lending practices in their local communities.
However, because of the impact that nonbank FIs, including finance companies,
had on the U.S. economy during the financial crisis and as a result of the need for
the Federal Reserve to rescue several nonbank FIs, regulators proposed that nonbank FIs receive more oversight. Indeed, as discussed earlier, at the height of the
financial crisis the Fed stepped in to rescue numerous finance companies, including
GMAC, GE Capital, and CIT Group. Credit card lenders American Express and Discover Financial (as well as investment banks Goldman Sachs and Morgan Stanley)
also became bank holding companies in 2008. As a result, as part of the 2010 Wall
Street Reform and Consumer Protection Act, the federal government was provided
with the tools it needs to manage financial crises by establishing (a) a new regime
to resolve nonbank financial institutions whose failure could have serious systemic
effects and (b) revisions to the Federal Reserve’s emergency lending authority to
improve accountability. The bill also proposed robust supervision and regulation of
all financial firms by establishing (a) a new Financial Services Oversight Council of
financial regulators (chaired by Treasury and including the heads of the principal
federal financial regulators as members) to identify emerging systemic risks and
improve interagency cooperation; (b) a new authority for the Federal Reserve to
supervise all firms that could pose a threat to financial stability, even those that do
not own banks; and (c) stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms.
Further, since finance companies are heavy borrowers in the capital markets and
do not enjoy the same regulatory “safety net” as banks, they need to signal their
solvency and safety to investors.9 Signals of solvency and safety are usually sent
by holding higher equity or capital-to-asset ratios—and therefore lower leverage
ratios—than banks hold. For example, in 2012 the aggregate balance sheet (Table 3–1)
shows a capital-to-assets ratio of 14.3 percent for finance companies. This can be
compared to the capital-to-asset ratio for commercial banks of 11.5 percent reported
in Table 2–6. Larger, captive finance companies also use default protection guarantees from their parent companies and/or guarantees such as letters of credit or lines
of credit purchased for a fee from high-quality commercial or investment banks as
additional protection against insolvency risk and as a device to increase their ability
to raise additional funds in the capital and money markets. Thus, this group will
tend to operate with lower capital-to-asset ratios than smaller finance companies.
Given that there is little regulatory oversight of this industry, having sufficient capital and access to financial guarantees are critical to their continued ability to raise
funds. Thus, finance companies operate more like nonfinancial, nonregulated companies than other types of financial institutions examined in this text.
Concept
Questions
1. Since finance companies seem to compete in the same lending markets as banks,
why are they not subject to the same regulations as banks?
2. How do finance companies signal solvency and safety to investors?
9
That is, they have no access to the deposit insurance fund or to the Federal Reserve discount window
(see Chapter 19). On the other hand, they do not have to pay deposit insurance premiums or meet regulatory imposed minimum capital standards.
82
Part One
Introduction
GLOBAL ISSUES
£ ¥
:$
Summary
While commercial banks are the most important source of credit supply in many
foreign countries, particularly emerging market economies, nonbank financial
institutions (finance companies, credit unions, and building societies) account
for a substantial part of the outstanding credit by all financial institutions and
their relative importance has been increasing over the past decade. Specialized
consumer finance agencies operate throughout western Europe, Canada, Australia, Japan, and some Latin American countries. For example, from the mid-1990s
to the late-2000s, the percentage of aggregate credit issued by nonbank financial
institutions increased from 22 to 32 percent in Latin America and from 4 to 17
percent in central Europe. In Thailand, nonbank financial institutions, particularly those specializing in credit card lending, gained market share. This trend
also occurred in Mexico, where specialized mortgage institutions dominated lowincome mortgage lending. Large sales finance companies specialize in financing
purchases of particular commodities and remain closely associated with specific
manufacturers. Some also extend credit for wholesale purchases by retail dealers. While the financial crisis affected the operations of finance companies, they
still remained a major part of the financial sector in countries worldwide. For
example, in New Zealand the financial crisis led to the consolidation, collapse,
and restructuring of many of the country’s finance companies. Further, in Russia
significant finance company staff reductions occurred during the financial crisis.
Because regulations in most foreign countries are not as restrictive as those in the
United States, finance companies in foreign countries are generally subsidiaries of commercial banks or industrial firms. For those finance companies owned
by commercial banks, as the bank goes, so does the finance company. Some of
the major multinational business financing companies include Alliance Leicester
Commercial Bank (part of Santander Group, United Kingdom), Commercial Lifeline (United Kingdom), Finance Eai (Australia), Five Arrows Commercial Finance
(Australia), Lloyds TSB (United Kingdom), Lombard (United Kingdom), and SME
Commercial Finance (Australia).
This chapter provided an overview of the finance company industry. This industry competes directly with depository institutions for high-quality (prime) loan
customers by specializing in consumer loans, real estate loans, and business loans.
The industry also services subprime (high-risk) borrowers deemed too risky for
most depository institutions. However, because firms in this industry do not
accept deposits, they are not regulated to the same extent as are depository institutions. Because they do not have access to deposits for their funding, finance companies rely heavily on short- and long-term debt, especially commercial paper.
Currently, the industry is generally growing and profitable, although the subprime lending sector of the industry is experiencing some financial problems as
consumer default rates on loans and credit cards rise.
Chapter 3
83
1. What is the primary function of finance companies? How do finance companies differ from depository institution?
2. What are the three major types of finance companies? To which market segments do each of these types of companies provide service?
3. What have been the major changes in the accounts receivable balances of
finance companies over the 35-year period 1977–2012?
4. What are the major types of consumer loans? Why are the rates charged by
consumer finance companies typically higher than those charged by commercial banks?
5. Why have home equity loans become popular? What are securitized mortgage assets?
6. What advantages do finance companies have over commercial banks in offering services to small business customers? What are the major subcategories of
business loans? Which category is the largest?
7. What have been the primary sources of financing for finance companies?
8. How do finance companies make money? What risks does this process entail?
How do these risks differ for a finance company versus a commercial bank?
9. Compare Tables 3–1 and 2–6. Which firms have higher ratios of capital to total
assets: finance companies or commercial banks? What does this comparison
indicate about the relative strengths of these two types of firms?
10. Why do finance companies face less regulation than do commercial banks?
How does this advantage translate into performance advantages? What is the
major performance disadvantage?
Web Question
11. Go to the Federal Reserve’s website at www.federalreserve.gov and get the
latest information on finance company consumer, real estate, and business
lending using the following steps. Click on “All Statistical Releases.” Under
“Business Finance,” click on “Finance Companies.” This downloads a file
onto your computer that contains the relevant data. How have these numbers
changed since 2012, reported in Table 3–4?
www.mhhe.com/saunders8e
Questions
and Problems
Financial Services: Finance Companies
Chapter Four
Financial Services:
Securities Brokerage
and Investment
Banking
INTRODUCTION
Securities firms and investment banks primarily help net suppliers of funds (e.g.,
households) transfer funds to net users of funds (e.g., businesses) at a low cost and
with a maximum degree of efficiency. Unlike other types of FIs, securities firms
and investment banks do not transform the securities issued by the net users of
funds into claims that may be “more” attractive to the net suppliers of funds (e.g.,
banks and their creation of bank deposits and loans). Rather, they serve as brokers
intermediating between fund suppliers and users.
Investment banking involves the raising of debt and equity securities for corporations or governments. This includes the origination, underwriting, and placement of securities in money and capital markets for corporate or government
issuers. Securities services involve assistance in the trading of securities in the
secondary markets (brokerage services and/or market making). Together these
services are performed by securities firms and investment banks. The largest companies in this industry perform both sets of services (i.e., underwriting and brokerage services). These full-line firms (e.g., Bank of America Merrill Lynch) are
generally called investment banks. Many other firms concentrate their services in
one area only (either securities trading or securities underwriting). That is, some
firms in the industry specialize in the purchase, sale, and brokerage of existing
securities (the retail side of the business) and are called securities firms, while other
firms specialize in originating, underwriting, and distributing issues of new securities (the commercial side of the business) and are called investment banks.
Investment banking also includes corporate finance activities such as advising
on mergers and acquisitions (M&As), as well as advising on the restructuring of
existing corporations. Figure 4–1 reports merger activity for the period 1990–2012.
Total dollar volume (measured by transaction value) of domestic M&As increased
from less than $200 billion in 1990 to $1.83 trillion in 2000 (reflecting 10,864 deals).
84
Chapter 4
Financial Services: Securities Brokerage and Investment Banking
85
FIGURE 4–1
Attracting Partners
Source: Thompson Reuters Deals Intelligence, 2013. www.thompsonreuters.com
$ 2,000 billion
Total value of
mergers and
acquisitions in the
United States (in
billions of dollars)
1,900
1,800
1,700
1,600
1,500
1,400
1,300
1,200
1,100
1,000
900
800
700
600
500
400
300
200
100
0
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
This merger wave was not restricted to the United States. For example, in 2000
there were more than 36,700 merger and acquisition deals globally, valued at more
than $3.49 trillion. However, reflecting the downturn in the U.S. economy, M&A
transactions fell 53 percent in 2001 to $819 billion on only 7,525 deals (the first time
since 1995 there were fewer than 10,000 deals). Similarly, worldwide M&As fell to
$1.74 trillion in 2001. Domestic M&A activity bottomed out at $458 billion in 2002
(while worldwide activity fell to $1.2 trillion) before recovering (along with the
economy), topping $1.7 trillion in the United States (and $4.5 trillion worldwide)
86
Part One
Introduction
in 2007. During the financial crisis, domestic M&A activity fell to $903 billion, $713
billion, and $687 billion in 2008, 2009, and 2010, respectively, while worldwide
M&As fell to $2.9 trillion, $1.7 trillion, and $1.8 trillion, respectively. Note that
while this period included the worst financial crisis since the Great Depression,
M&A activity remained at higher levels than those experienced in the early 2000s.
As the U.S. economy recovered in 2011 and 2012, M&A activity rose as well (to
$861 billion and $882 billion, respectively, while worldwide activity increased to
$2.33 trillion and $2.04 trillion, respectively).
The industry has undergone substantial structural changes in recent years.
Some of the most recent consolidations include the acquisition of Bear Stearns
by J.P. Morgan Chase, the bankruptcy of Lehman Brothers, and the acquisition of
Merrill Lynch by Bank of America. Indeed, as discussed later in the chapter, the
investment banking industry has seen the failure or acquisition of all but two of its
major firms (Goldman Sachs and Morgan Stanley), and these two firms converted
to commercial bank holding companies in 2008.
In this chapter we present an overview of (1) the size, structure, and composition of the industry, (2) the balance sheet and recent trends, and (3) the regulation
of the industry. After studying the chapter, the reader should have a basic understanding of financial services involving securities brokerage and investment banking, as well as the major trends in the industry.
SIZE, STRUCTURE, AND COMPOSITION OF THE INDUSTRY
Because of the emphasis on securities trading and underwriting, the size of the
industry is usually measured by the equity capital of the firms participating in
these financial services. Securities trading and underwriting is a financial service that requires no investment in assets or liability funding (such as the issuance of loans funded through deposits or payments on insurance contracts funded
through insurance premiums). Rather, securities trading and underwriting is a
profit-generating activity that does not require FIs to actually hold or invest in
the securities they trade or issue for their customers, except for very short periods
either as part of their trading inventory or during the underwriting period for new
issues. Accordingly, asset value is not traditionally a measure of the size of a firm
in this industry. Instead, the equity or capital of the FI is used as the most common
benchmark of relative size. Equity capital in this industry amounted to $205.9 billion in 2012, supporting total assets of $4.55 trillion.
Beginning in 1980 and extending up to the stock market crash of October 19,
1987, the number of firms in the industry expanded dramatically from 5,248 to
9,515. The aftermath of the crash saw a major shakeout, with the number of firms
declining to 6,016 by 2006, a decline of 37 percent since 1987. Concentration of
business among the largest firms over this period increased dramatically. Some of
the significant growth in size came through M&As among the top ranked firms.
Table 4–1 lists major U.S. securities industry M&A transactions, many of which
involve repeated ownership changes of the same company. Notice from this
table that many recent mergers and acquisitions have been interindustry mergers (i.e., insurance companies and investment banks). Recent regulatory changes
such as the Financial Services Modernization Act of 1999 (discussed in Chapter 2
and described in more detail in Chapter 21) are a primary cause for such mergers. In fact, note in Table 4–1 that a majority of the securities’ industry mergers
Chapter 4
TABLE 4–1
Major U.S.
Securities
Industry Merger
and Acquisition
Transactions
Sources: Thomson Financial
Securities Data; The Wall
Street Journal; and authors’
figures.
Rank
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Financial Services: Securities Brokerage and Investment Banking
Deal
Citicorp merges with Travelers
(which owns Smith Barney and Salomon)
J.P. Morgan acquires Bank One*
Bank of America acquires Merrill Lynch
Bank of America acquires FleetBoston*
Bank of America acquires Merrill Lynch
Chase acquires J.P. Morgan*
Bank of America acquires MBNA*
Wachovia acquires Golden West Financial*
Wachovia acquires Southtrust*
BlackRock Inc. acquires Barclays Global
UBS acquires Paine Webber Group
Credit Suisse First Boston acquires
Donaldson Lufkin Jenrette
Dean Witter merges with Morgan Stanley†
Deutsche Bank acquires Bankers Trust*
Region’s Financial acquires AmSouth*
CME Group acquires NYMEX Holdings
Travelers acquires Salomon Inc.
Intercontinental Exchange acquires NYSE
Goldman Sachs acquires Spear, Leeds & Kellogg
J.P. Morgan acquires Bear Stearns
87
Price ($ billions)
Year
$83.0
60.0
50.0
49.3
47.1
35.0
35.0
25.5
14.3
13.5
12.0
1998
2004
2008
2003
2008
2000
2005
2006
2004
2009
2000
11.5
10.2
10.1
10.0
9.5
9.0
8.2
6.5
0.2
2000
1997
1998
2006
2008
1997
2012
2000
2008
* These organizations own Section 20 securities subsidiaries and/or are established financial service holding companies
under the 1999 Financial Services Modernization Act.
†
Value of Dean Witter, Discover shares to be exchanged for Morgan Stanley stock, based on closing price of $40.625 on February 5, 1997.
broker–dealers
Assist in the trading
of existing securities.
underwriting
Assisting in the issue
of new securities.
and acquisitions occurring in the 2000s include securities firms that are a part of a
financial services holding company.
The financial crisis resulted in a second major change in the structure of the
industry. The five largest investment banks in existence at the beginning of 2008
(Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley) were all gone as investment banks by the end of the year. Lehman Brothers failed at the start of the financial crisis, Bear Stearns and Merrill Lynch were
acquired by financial services holding companies (J.P. Morgan Chase and Bank of
America, respectively), and Goldman Sachs and Morgan Stanley requested and
were granted commercial bank charters. As of 2011, commercial bank holding
companies’ fee income from securities brokerage topped $40.28 billion, up from
$16.47 billion in 2007, and more than 65 percent of the industry total. Table 4–2
lists the top bank holding companies in terms of securities brokerage fee income.
Further, the number of securities firms continued to fall to 4,481 by 2012. The
investment banking industry was irrevocably changed.
In its changed state, firms in the industry can be divided along a number of
dimensions. The largest firms, the so-called national full-line firms, service both
retail customers (especially in acting as broker–dealers, thus assisting in the trading of existing securities) and corporate customers (such as underwriting, thus
assisting in the issue of new securities). With the changes in the past few years,
national full-line firms now fall into three subgroups. First are the commercial bank
88
Part One
Introduction
TABLE 4–2
Bank Holding
Company
Top Bank Holding
Companies
in Securities
Brokerage Fee
Income, 2011 (in
billions of dollars)
Bank of America
Morgan Stanley
Wells Fargo
Goldman Sachs
J.P. Morgan Chase
All bank holding companies
Securities Brokerage
Fee Income
$ 9.93
7.47
4.75
3.01
2.75
$36.81
holding companies that are the largest of the full service investment banks. They
have extensive domestic and international operations and offer advice, underwriting, brokerage, trading, and asset management services. The largest of these firms
include Bank of America (through their acquisition of Merrill Lynch), Morgan Stanley, and J.P. Morgan Chase (through its many acquisitions, including that of Bear
Stearns, for $240 million in 2008). Second are the national full-line firms that specialize more in corporate business with customers and are highly active in trading
securities. Examples are Goldman Sachs and Salomon Brothers/Smith Barney, the
investment banking arm of Citigroup (created from the merger of Travelers and
Citicorp in 1998). Third are the large investment banks. These firms maintain more
limited branch networks concentrated in major cities operating with predominantly
institutional client bases. These firms include Lazard Ltd. and Greenhill & Co.
The rest of the industry is comprised of firms that perform a mix of primary
and secondary market services for a particular segment of the financial markets:
discount brokers
Stockbrokers that
conduct trades for
customers but do
not offer investment
advice.
1. Regional securities firms that are often subdivided into large, medium, and
small categories and concentrate on servicing customers in a particular region,
e.g., New York or California (such as Raymond James Financial).
2. Specialized discount brokers that effect trades for customers on- or offline
without offering investment advice or tips (such as Charles Schwab).
3. Specialized electronic trading securities firms (such as E*trade) that provide a
platform for customers to trade without the use of a broker. Rather, trades are
enacted on a computer via the Internet.1
4. Venture capital firms that pool money from individual investors and other FIs
(e.g., hedge funds, pension funds, and insurance companies) to fund relatively
small and new businesses (e.g., in biotechnology).2
5. Other firms in this industry include research boutiques, floor specialists, companies with large clearing operations, and other firms that do not fit into one
of the preceding categories. This would include firms such as Knight Capital
Group (a leading firm in off-exchange trading of U.S. equities) and floor specialist LaBranche & Co.
Securities firms and investment banks engage in as many as seven key activity
areas investment banking, venture capital, market making, trading, investing,
1
Discount brokers and electronic trading securities firms usually charge lower commissions than do fullservice brokers such as Merrill Lynch.
2
Venture capital firms generally play an active management role in the firms in which they invest, often
including a seat on the board of directors, and hold significant equity stakes. This differentiates them
from traditional banking and securities firms.
Chapter 4
Financial Services: Securities Brokerage and Investment Banking
TABLE 4–3
Top Underwriters
of Global Debt and
Equity
Source: Thompson Reuters
Deals Intelligence, 2013.
www.thompsonreuters.com
Full Year 2012
Manager
J.P. Morgan
Deutsche Bank
Barclays Capital
Citigroup
Bank of America
Merrill Lynch
Top ten
Industry total
89
Full Year 2011
Amount
(billions)
Market
Share
Amount
(billions)
Rank
Market
Share
$ 488.6
409.7
384.6
373.6
7.9%
6.6
6.2
6.0
$ 384.8
371.3
365.9
305.6
1
2
3
5
6.9%
6.7
6.6
5.5
339.1
$3,323.2
$6,191.7
5.5
53.6%
100.0%
325.6
$2,958.4
$5,569.7
4
5.9
53.2%
100.0%
cash management, mergers and acquisitions, and other service functions. As we
describe each of these, note that while each activity is available to a firm’s customers independently, many of these activities can be and are conducted simultaneously (such as mergers and acquisitions financed by new issues of debt and equity
underwritten by the M&A advising firm) for a firm’s customers.
1. Investment Banking
IPO
An initial, or first
time, public offering
of debt or equity by a
corporation.
private placement
A securities issue
placed with one or a
few large institutional
investors.
Investment banking refers to activities related to underwriting and distributing
new issues of debt and equity. New issues can be either primary, the first-time
issues of companies (sometimes called IPOs [initial public offerings]), or secondary issues (the new issues of seasoned firms whose debt or equity is already trading). In 2012, a total of $6.19 trillion of debt and equity was underwritten. This was
up from $4.95 trillion underwritten in 2008 during the financial crisis, but well
below the pre-crisis amounts of $7.51 and $7.84 trillion in 2007 and 2006, respectively. Table 4–3 lists the top 5 underwriters of global debt and equity for 2011 and
2012. The top 5 underwriters represented 32.2 percent and the top 10 firms represented more than 50 percent of the industry total, suggesting that the industry
is dominated by a handful of top-tier underwriting firms. Top-tier rating and the
implied reputation this brings has a huge effect in this business. At times, investment banks have refused to participate in an issue because their name would not
be placed where they desired it on the “tombstone” advertisement announcing
the issue and its major underwriters.
Securities underwritings can be undertaken through either public offerings or
private offerings. In a private offering, the investment banker acts as a private
placement agent for a fee, placing the securities with one or a few large institutional investors such as life insurance companies. In a public offering, the securities may be underwritten on a best-efforts or a firm commitment basis, and the
securities may be offered to the public at large. With best-efforts underwriting,
investment bankers act as agents on a fee basis related to their success in placing the issue. In a firm commitment underwriting, the investment banker acts as
a principal, purchasing the securities from the issuer at one price and seeking to
place them with public investors at a slightly higher price. Finally, in addition
to investment banking operations in the corporate securities markets, investment
banks may participate as an underwriter (primary dealer) in government, municipal, and asset-backed securities. Table 4–4 shows the top-ranked underwriters for
2012 and 2011 in the different areas of securities underwriting.
90
Part One
TABLE 4–4
Introduction
Who Is the Lead Underwriter in Each Market?
Source: Thompson Reuters Deals Intelligence, 2013. www.thompsonreuters.com
Full Year 2012
Full Year 2011
Type
Amount
(billions)
Top-Ranked
Manager
Amount
(billions)
Top-Ranked
Manager
Total debt
Convertible debt
Investment-grade debt
Mortgage-backed securities
$5,557.2
64.2
2,655.3
462.0
J.P. Morgan
Deutsche Bank
J.P. Morgan
Deutsche Bank
$4,952.2
65.4
2,258.7
521.5
Barclays Capital
Goldman Sachs
J.P. Morgan
Bank of America
Merrill Lynch
Bank of America
Merrill Lynch
Goldman Sachs
Goldman Sachs
J.P. Morgan
Asset-backed securities
Common stock
IPOs
Syndicated loans
EXAMPLE 4–1
Best Efforts
versus Firm
Commitment
Securities
Offering
321.0
566.2
117.4
3,226.8
J.P. Morgan
Goldman Sachs
Morgan Stanley
J.P. Morgan
243.0
551.9
163.8
3,934.0
An investment bank agrees to underwrite an issue of 20 million shares of stock for Murray
Construction Corp. on a firm commitment basis. The investment bank pays $15.50 per share
to Murray Construction Corp. for the 20 million shares of stock. It then sells those shares to the
public for $16.35 per share. How much money does Murray Construction Corp. receive? What is
the profit to the investment bank? If the investment bank can sell the shares for only $14.75, how
much money does Murray Construction Corp. receive? What is the profit to the investment bank?
If the investment bank sells the stock for $16.35 per share, Murray Construction Corp.
receives $15.50 ⫻ 20,000,000 shares ⫽ $310,000,000. The profit to the investment bank is
($16.35 ⫺ $15.50) ⫻ 20,000,000 shares ⫽ $17,000,000. The stock price of Murray Construction Corp. is $16.35 since that is what the public agrees to pay. From the perspective of Murray
Construction Corp., the $17 million represents the commission that it must pay to issue the stock.
If the investment bank sells the stock for $14.75 per share, Murray Construction Corp. still
receives $15.50 ⫻ 20,000,000 shares ⫽ $310,000,000. The profit to the investment bank is
($14.75 ⫺ $15.50) ⫻ 20,000,000 shares ⫽ ⫺$15,000,000. The stock price of Murray Construction Corp. is $14.75 since that is what the public agrees to pay. From the perspective of
the investment bank, the ⫺$15 million represents a loss for the firm commitment it made to
Murray Construction Corp. to issue the stock.
Suppose, instead, that the investment bank agrees to underwrite the 20 million shares
on a best-efforts basis. The investment bank is able to sell 18.4 million shares for $15.50 per
share, and it charges Murray Construction Corp. $0.375 per share sold. How much money
does Murray Construction Corp. receive? What is the profit to the investment bank? If the
investment bank can sell the shares for only $14.75, how much money does Murray Construction Corp. receive? What is the profit to the investment bank?
If the investment bank sells the stock for $15.50 per share, Murray Construction Corp.
receives ($15.50 ⫺ $0.375) ⫻ 18,400,000 shares ⫽ $278,300,000, the investment bank’s
profit is $0.375 ⫻ 18,400,000 shares ⫽ $6,900,000, and the stock price is $15.50 per share
since that is what the public pays.
If the investment bank sells the stock for $14.75 per share, Murray Construction Corp.
receives ($14.75 ⫺ $0.375) ⫻ 18,400,000 shares ⫽ $264,500,000, the investment bank’s
profit is still $0.375 ⫻ 18,400,000 shares ⫽ $6,900,000, and the stock price is $14.75 per
share since that is what the public pays.
Chapter 4
Financial Services: Securities Brokerage and Investment Banking
91
2. Venture Capital
venture capital
A professionally managed pool of money
used to finance new
and often high-risk
firms.
institutional
venture capital
firms
Business entities
whose sole purpose is
to find and fund the
most promising new
firms.
angel venture
capitalists (or
angels)
Wealthy individuals
who make equity
investments.
A difficulty for new and small firms in obtaining debt financing from commercial banks (or CBs) is that CBs are generally not willing or able to make loans to
new companies with no assets and business history. In this case, new and small
firms often turn to investment banks (and other firms) that make venture capital investments to get capital financing as well as advice. Venture capital is a
professionally managed pool of money used to finance new and often high-risk
firms. Venture capital is generally provided to back an untried company and its
managers in return for an equity investment in the firm. Venture capital firms
do not make outright loans. Rather, they purchase an equity interest in the firm
that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners. The terms venture capital and private equity
are often used interchangeably. However, there are distinct differences in the two
types of investment institutions. For example, venture capital firms generally,
using the pooled investment resources of institutions and wealthy individuals,
concern themselves more with startup business concerns. Private equity firms
acquire the investment funds they use from sources such as equity securities and
non–publicly traded stocks as well as the institutional and individual investment pooling used by venture capital firms. Further, venture capital firms tend
to utilize teams of either scientific or business professionals to help identify new
and emerging technologies in which to place their money. Private equity firms
deal more with existing companies that have already proven themselves in the
business field. As a result of the financial crisis, the differences between venture
capital firms and private equity firms have become less distinct. With fewer new
ventures being brought forth, there has been greater competition between the
two types of investment institutions, with both searching for and funding the
same types of new and small firms.
There are many types of venture capital firms. Institutional venture capital
firms are business entities whose sole purpose is to find and fund the most promising new firms. Private sector institutional venture capital firms include venture
capital limited partnerships (that are established by professional venture capital
firms, acting as general partners in the firm: organizing and managing the firm
and eventually liquidating their equity investment), financial venture capital firms
(subsidiaries of investment or commercial banks), and corporate venture capital
firms (subsidiaries of nonfinancial corporations that generally specialize in making startup investments in high-tech firms). Limited partner venture capital firms
dominate the industry. In addition to these private sector institutional venture
capital firms, the federal government, through the Small Business Administration
(SBA), operates small business investment companies (SBICs). SBICs are privately
organized venture capital firms licensed by the SBA that make equity investments
(as well as loans) to entrepreneurs for startup activities and expansions. As federally sponsored entities, SBICs have relied on their unique opportunity to obtain
investment funds from the U.S. Treasury at very low rates relative to private sector institutional venture capital firms. In contrast to institutional venture capital
firms, angel venture capitalists (or angels) are wealthy individuals who make
equity investments. Angel venture capitalists have invested much more in new
and small firms than institutional venture capital firms.
Venture capital firms receive many unsolicited proposals of funding from new
and small firms. A majority of these requests are rejected. Venture capital firms
look for two things in making their decisions to invest in a firm. The first is a
92
Part One
Introduction
high return. Venture capital firms are willing to invest in high-risk new and small
firms. However, they require high levels of returns (sometimes as high as 700 percent within five to seven years) to take on these risks. The second is an easy exit.
Venture capital firms realize a profit on their investments by eventually selling
their interests in the firm. They want a quick and easy exit opportunity when it
comes time to sell. Basically, venture capital firms provide equity funds to new,
unproven, and young firms. This separates venture capital firms from commercial
banks, which prefer to invest in existing, financially secure businesses.
3. Market Making
Market making involves creating a secondary market in an asset by a securities
firm or investment bank. Thus, in addition to being primary dealers in government securities and underwriters of corporate bonds and equities, investment
banks make a secondary market in these instruments. Market making can involve
either agency or principal transactions. Agency transactions are two-way transactions on behalf of customers, for example, acting as a stockbroker or dealer for a fee
or commission. On the NYSE, a market maker in a stock such as IBM may, upon
the placement of orders by its customers, buy the stock at $190 from one customer
and immediately resell it at $191 to another customer. The $1 difference between
the buy and sell price is usually called the bid–ask spread and represents a large
portion of the market maker’s profit.
In principal transactions, the market maker seeks to profit on the price movements of securities and takes either long or short inventory positions for its own
account. (Or an inventory position may be taken to stabilize the market in the
securities.) In the example above, the market maker would buy the IBM stock at
$190 and hold it in its own portfolio in expectation of a price increase later on.
Normally, market making can be a fairly profitable business. However, in periods
of market stress or high volatility, these profits can rapidly disappear. For example, on the NYSE, market makers, in return for having monopoly power in market
making for individual stocks (e.g., IBM), have an affirmative obligation to buy
stocks from sellers even when the market is crashing. This caused a number of
actual and near bankruptcies for NYSE market makers at the time of the October
1987 market crash. On NASDAQ, which has a system of competing market makers, liquidity was significantly impaired at the time of the crash and a number
of firms had to withdraw from market making. Finally, the recent moves toward
decimalization of equities markets in the United States (i.e., expressing quotes in
integers of 1 cent [e.g., $50.32] rather than rounding to eighths [e.g., 503/8]) has cut
into traders’ profits, as has competition from Internet-based or electronic-based
exchanges such as Instinet Group.
4. Trading
Trading is closely related to the market-making activities just described, where a
trader takes an active net position in an underlying instrument or asset. There are
at least six types of trading activities:
1. Position trading involves purchasing large blocks of securities on the expectation of a favorable price move. Position traders maintain long or short positions
for intervals of up to several weeks or even months. Rather than attempting to
profit from very short-term movements in prices, as day traders do, position
traders take relatively longer views of market trends. Such positions also facilitate the smooth functioning of the secondary markets in such securities.
Chapter 4
Financial Services: Securities Brokerage and Investment Banking
93
2. Pure arbitrage entails buying an asset in one market at one price and selling
it immediately in another market at a higher price. Pure arbitrage “locks in”
profits that are available in the market. This profit position usually occurs with
no equity investment, the use of only very short-term borrowed funds, and
reduced transaction costs for securities firms. Pure arbitrageurs often attempt
to profit from price discrepancies that may exist between the spot, or cash, price
of a security and its corresponding futures price. Some important theoretical
pricing relationships in futures markets should exist with spot markets and
prices. When these relationships get out of line, pure arbitrageurs enter the
market to exploit them.
3. Risk arbitrage involves buying securities in anticipation of some information
release, such as a merger or takeover announcement or a Federal Reserve interest rate announcement. It is termed risk arbitrage because if the event does not
actually occur—for example, if a merger does not take place or the Federal
Reserve does not change interest rates—the trader stands to lose money.
4. Program trading is defined by the NYSE as the simultaneous buying and selling
of a portfolio of at least 15 different stocks valued at more than $1 million, using
computer programs to initiate such trades. Program trading is often associated
with seeking a risk arbitrage between a cash market price (e.g., the Standard
& Poor’s 500 Stock Market Index) and the futures market price of that instrument.3 Because computers are used to continuously monitor stock and futures
prices—and can even initiate buy or sell orders—these trades are classified separately as program trading.
5. Stock brokerage involves the trading of securities on behalf of individuals who
want to transact in the money or capital markets. To conduct such transactions,
individuals contact their broker (such as Merrill Lynch), which then sends the
orders to its representative at the exchange to conduct the trades. Large brokerage firms often have several licenses on the floor of a stock exchange (e.g.,
NYSE), through which their commission brokers trade orders from the firm’s
clients or for the firms own account.
6. Electronic brokerage, offered by major brokers, involves direct access, via the
Internet, to the trading floor, therefore bypassing traditional brokers. Many
securities firms and investment banks offer online trading services to their customers as well as direct access to a client representative (stockbroker). Thus,
customers may now conduct trading activities from their homes and offices
through their accounts at securities firms. Because services provided by a typical brokerage firm are bypassed, the cost per share is generally lower and the
price may be advantageous compared with trading directly on the exchanges.
Users of the system can often use the network to discover existing sizes and
quotes of offers to buy or sell. Interested parties can then negotiate with each
other using the system’s computers.
As with many activities of securities firms, such trading can be conducted on
behalf of a customer as an agent (or broker), or on behalf of the firm as a principal.
When trading at the retail level occurs on behalf of customers, it is often called
brokerage (or stock brokering).
3
An example would be buying the cash S&P index and selling futures contracts on the S&P index. Since
stocks and futures contracts trade in different markets, their prices are not always equal. Moreover,
program trading can occur between futures and cash markets in other assets, e.g., commodities.
94
Part One
Introduction
5. Investing
Investing involves managing not only pools of assets such as closed- and open
end mutual funds but also pension funds in competition with life insurance companies. Securities firms can manage such funds either as agents for other investors
or as principals for themselves. The objective in funds management is to choose
asset allocations to beat some return–risk performance benchmark such as the
S&P 500 index. Since this business generates fees that are based on the size of the
pool of assets managed, it tends to produce a more stable flow of income than
does either investment banking or trading.
6. Cash Management
cash management
accounts
Money market
mutual funds sold
by investment
banks; most CMAs
offer check-writing
privileges.
Investment banks offer bank deposit-like cash management accounts (CMAs)
to individual investors and since the 1999 Financial Services Modernization Act,
deposit accounts themselves (Merrill Lynch was the first investment bank to offer
a direct deposit account in June 2000, via the two banks it owned). Most of these
CMAs allow customers to write checks against some type of mutual fund account
(e.g., money market mutual fund). These accounts, when issued in association
with commercial banks and thrifts, can even be covered by federal deposit insurance from the FDIC. CMAs were adopted by other security firms under various
names (e.g., house account) and spread rapidly. Many of these accounts offer ATM
services and debit cards. As a result of CMAs, the distinction between commercial
banks and investment banks became blurred. However, the advantage of brokerage firm CMAs over commercial bank deposit accounts is that they make it easier
to buy and sell securities. The broker can take funds out of the CMA account when
an investor buys a security and deposit funds back into the CMA when the investor sells securities. CMAs were instrumental in the securities industry’s efforts to
provide commercial banking services prior to the 1999 Financial Services Modernization Act. Since the passage of this regulation, securities firms are allowed to
make loans, offer credit and debit cards, provide ATM services, and, most importantly, sell securities.
7. Mergers and Acquisitions
Investment banks are frequently involved in providing advice or assisting in
mergers and acquisitions. For example, they will assist in finding merger partners, underwriting new securities to be issued by the merged firms, assessing the
value of target firms, recommending terms of the merger agreement, and even
helping target firms prevent a merger (e.g., seeing that poison-pill provisions are
written into a potential target firm’s securities contracts). As noted in the introduction to this chapter, U.S. merger and acquisition activity stood at $882 billion in
2012. Panel A of Table 4–5 lists the top 10 investment bank merger advisors ranked
by dollar volume of domestic mergers in which they were involved. Panel B of
Table 4–5 lists the top 10 investment banks ranked by dollar volume of worldwide
M&A activity. Notice that many of the top U.S.-ranked investment banks reported
in panel A of Table 4–5 are also top-ranked for worldwide activity in panel B.
8. Back-Office and Other Service Functions
These functions include custody and escrow services, clearance and settlement
services, and research and other advisory services—for example, giving advice on
divestitures and asset sales. In addition, investment banks are making increasing
inroads into traditional bank service areas such as small business lending and the
Chapter 4
TABLE 4–5
Ten Largest Merger
and Acquisition
Firms Ranked by
Value of Mergers,
2012
Source: Thompson Reuters
Deals Intelligence, 2013.
www.thompsonreuters.com
Financial Services: Securities Brokerage and Investment Banking
95
Panel A: Mergers Completed in U.S.
Rank
1
2
3
4
5
6
7
8
9
10
Investment Bank
Goldman Sachs
J.P. Morgan
Barclays Capital
Credit Suisse
Morgan Stanley
Evercore Partners
Citigroup
Bank of America Merrill Lynch
Lazard
Deutsche Bank
Industry total
Value
($ billions)
$299.8
241.5
229.9
216.7
175.2
140.9
134.1
131.5
124.8
101.3
$882.1
Number
of Deals
140
114
120
86
95
65
72
91
91
66
6,951
Panel B: Worldwide Mergers
Rank
1
2
3
4
5
6
7
8
9
10
Investment Bank
Goldman Sachs
J.P. Morgan
Morgan Stanley
Credit Suisse
Barclays Capital
Bank of America Merrill Lynch
Deutsche Bank
Citigroup
Lazard
Rothschild
Industry total
Credit Lent
($ billions)
$ 570.2
406.4
379.4
354.5
321.6
274.2
265.0
238.1
220.0
164.6
$2,040.6
Number
of Deals
352
247
320
231
235
192
216
184
223
234
28,454
trading of loans (see Chapter 21). In performing these functions, an investment
bank normally acts as an agent for a fee. As mentioned above, fees charged are
often based on the total bundle of services performed for the client by the firm.
The portion of the fee or commission allocated to research and advisory services
is called soft dollars. When one area in the firm, such as an investment advisor,
uses client commissions to buy research from another area in the firm, it receives
a benefit because it is relieved from the need to produce and pay for the research
itself. Thus, the advisor using soft dollars faces a conflict of interest between the
need to obtain research and the client’s interest in paying the lowest commission
rate available. Because of the conflict of interest that exists, the SEC (the primary
regulator of investment banks and securities firms) requires these firms to disclose
soft dollar arrangements to their clients.
Nevertheless, in the early and mid-2000s tremendous publicity was generated
concerning conflicts of interest in a number of investment banks between analysts’ research recommendations on stocks to buy or not buy and whether the firm
played a role in underwriting the securities of the firm the analysts were recommending. After an investigation by the New York State Attorney General, Merrill
96
Part One
Introduction
Lynch agreed to pay a fine of $100 million and to follow procedures more clearly
separating analysts’ recommendations (and their compensation) from the underwriting activities of the firm. A number of other major Wall Street firms were also
placed under investigation (discussed later). The investigation was triggered by
the dramatic collapse of many new technology stocks while analysts were still
making recommendations to buy or hold them.
Concept
Questions
1. Describe the difference between brokerage services and underwriting services.
2. What are the key areas of activities for securities firms and investment banks?
3. Describe the difference between a best-efforts offering and a firm commitment
offering.
4. What are the trading activities performed by securities firms and investment banks?
BALANCE SHEET AND RECENT TRENDS
Recent Trends
In this section, we look at the balance sheet and trends in the securities firm and
investment banking industry. Trends in this industry depend heavily on the state of
the stock market. For example, a major effect of the 1987 stock market crash was a
sharp decline in stock market trading volume and thus in brokerage commissions
earned by securities firms over the 1987–91 period. The overall decline in brokerage
commissions actually began more than 35 years ago, in 1977. The decline is reflective of a long-term fall in the importance of commission income, as a percentage
of revenues, for securities firms as a result of the abolition of fixed commissions
on securities trades imposed by the Securities and Exchange Commission (SEC)
in May 1975 and the fierce competition for wholesale commissions and trades that
followed (see Figure 4–2). Commission income began to stabilize and recover only
after 1992, with record equity trading volumes being achieved in 1995–2000 when
the Dow Jones and S&P indexes hit new highs. Improvements in the U.S. economy in the mid-2000s resulted in even greater increases in stock market values and
trading and thus commission income. However, rising oil prices and the subprime
mortgage market collapse and the eventual full market crash in 2008–09 pushed
stock market values down. As a result, commission income in the securities industry declined as well. As the economy and the stock market recovered in the early
2010s, commission income again rose to almost 20 percent of total revenues.
Also affecting the profitability of the securities industry was the decline in
new equity issues over the 1987–90 period as well as a decline in bond and equity
underwriting in general (see Table 4–6). This was due partly to the stock market
crash, partly to a decline in mergers and acquisitions, partly to a general economic
recession, and partly to investor concerns about the high-risk junk-bond market,
which crashed during this period. Between 1991 and 2001, however, the securities
industry showed a resurgence in profitability. For example, domestic underwriting activity over the 1990–2001 period grew from $192.7 billion in 1990 to $1,623.9
billion in 2001 (see Table 4–6). The principal reasons for this were enhanced trading profits and increased growth in new issue underwritings. In particular, corporate debt issues became highly attractive to corporate treasurers because of
relatively low long-term interest rates. Moreover, growth in the asset-backed
Chapter 4
FIGURE 4–2
Financial Services: Securities Brokerage and Investment Banking
97
Commission Income as a Percentage of Total Revenues
Sources: Securities and Exchange Commission, Standard & Poor’s Industry Surveys, and Securities Industry and Financial Markets Association.
45%
40
35
30
25
20
15
10
1977
TABLE 4–6
1980
1985
1990
1995
Year
2000
2005
2010
U.S. Corporate Underwriting Activity (in billions of dollars)
Source: Securities Industry and Financial Markets Association. www.sifma.com
Straight
ConAssetNon
Corporate vertible Backed agency
Debt
Debt
Debt
MBS
1986
134.9
9.8
1987
108.5
10.3
1990
76.5
5.5
1995
279.8
12.0
2000
587.5
49.6
2001
776.1
78.3
2002
635.4
30.5
2005
752.8
30.1
2006 1,058.9
62.8
2007 1,128.3
76.4
2008
707.2
42.0
2009
901.9
33.0
2010 1,062.8
29.1
2011 1,012.1
20.7
2012 1,354.5
19.7
% Change 33.8% ⫺5.1%
(YTD 2011 to YTD 2012)
10.0
8.9
43.6
113.1
337.0
383.3
496.2
753.5
753.9
509.7
163.3
150.9
107.5
124.8
199.4
59.8%
62.2
83.3
43.2
36.5
102.1
216.5
263.9
901.2
917.4
773.9
45.0
32.4
19.0
22.9
39.3
71.1%
Total
Debt
216.9
211.0
168.8
441.4
1,076.2
1,454.2
1,399.0
2,437.6
2,793.0
2,488.2
957.4
1,118.2
1,218.4
1,180.5
1,612.9
36.6%
Common Preferred Total
Stock
Stock
Equity
43.2
41.5
19.2
82.0
189.1
128.4
116.4
160.5
157.2
187.5
164.9
254.6
239.5
185.1
245.1
32.4%
13.9
11.4
4.7
15.1
15.4
41.3
37.6
29.9
33.4
60.0
77.3
9.6
22.2
13.3
32.5
144.4%
57.1
52.9
23.9
97.1
204.5
169.7
154.0
190.4
190.5
247.5
242.3
264.2
261.7
198.4
277.6
39.9%
All IPOs
22.3
24.0
10.1
30.2
76.1
40.8
41.2
62.6
57.9
91.1
11.0
26.9
52.0
47.8
55.4
15.7%
Total
Underwriting
274.0
263.9
192.7
538.5
1,280.7
1,623.9
1,553.0
2,628.0
2,983.5
2,735.7
1,199.7
1,382.4
1,480.0
1,378.9
1,890.5
37.1%
Note: High-yield bonds represent a subset of straight corporate debt. IPOs are a subset of common stock; true and closed-end fund IPOs are subsets of all IPOs.
98
Part One
FIGURE 4–3
Introduction
Securities Industry Pretax Profits, 1990–2012
Source: Securities Industry and Financial Markets Association, various years. www.sifma.com
Billlons
$75
65
55
45
35
25
15
5
−51990
Year
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
−15
−25
−35
securities market as a result of increased securitization of mortgages (and growth
of mortgage debt) added to the value of underwriting.4
As a result of enhanced trading profits and growth in new issue underwriting,
pretax net income for the industry topped $9 billion each year over the 1996–2000
period (see Figure 4–3). This is despite the collapse of the Russian ruble and bond
markets, economic turmoil in Asia, and political uncertainty in Washington during this period. Possibly more surprising is that despite a downturn in the U.S.
economy toward the end of 2000, pretax profits soared to an all-time high of
$31.6 billion in 2000. The continued slowdown of the U.S. economy in 2001 and
the terrorist attacks on the World Trade Center (which housed offices of many
securities firms and investment banks) in September 2001, however, brought an
end to these record profits. Industry pretax profits for the year 2001 fell 24 percent,
to $16 billion. The Bank of New York alone estimated costs associated with the
terrorist attacks were $125 million. Citigroup estimated it lost $100–$200 million
in business from branches that were closed and because of the four days the stock
market did not trade. Morgan Stanley, the largest commercial tenant in the World
Trade Center, said the cost of property damage and relocation of its employees
was $150 million. Also impacting profit, the securities industry was rocked by
several allegations of securities law violations as well as a loss of investor confidence in Wall Street and corporate America as a result of a number of corporate
governance failures and accounting scandals involving Enron, Merck, WorldCom,
and other major U.S. corporations.
With the recovery of the U.S. economy in the mid-2000s, the U.S. securities
industry again earned record profits as revenue growth strengthened and became
4
Another sign of the resurgence in this industry during the 1990s appears in employment figures.
Annual U.S. securities industry employment increased by 72 percent (from 486,000 jobs in 1992 to
837,000 in 2000 [peaking at 840,900 in March 2001]).
Chapter 4
Financial Services: Securities Brokerage and Investment Banking
99
more broadly based. Domestic underwriting surged to $2,983.5 billion in 2006,
from $1,553.0 billion in 2002 (see Table 4–6). Further, the industry increased its
profitability through deep cuts in expenses. Total expenses fell 10.4 percent from
2002 levels, largely due to lower interest expenses. Interest expense fell an estimated 22.5 percent from $48.4 billion in 2002 to $37.5 billion in 2003. The results
for 2003 were a surge in pretax profits to $24.1 billion (see Figure 4–3). Interest rate
increases in 2005 caused interest expense incurred by the securities industry to
increase. The result was that, while gross revenues remained high, the increased
interest expense caused pretax profits to fall to $17.6 billion in 2005. A surge in
revenues from trading gains and corporate advisory services caused pretax profits
to bounce back to a record level of $33.1 billion for 2006.
Signs of the impending financial crisis arose in 2007. The industry began 2007
on a strong note but, hit by the subprime mortgage market meltdown that began
in the summer of 2007, ended the year with pretax profits of just $0.78 billion.
Many revenue lines showed solid growth in 2007, and total revenues reached a
record high of $474.2 billion. However, trading and investment account losses
were large, totaling a loss of $6 billion in 2007 compared with a gain of $43 billion
in 2006. Further, expenses grew faster than revenues, to a record $473.4 billion in
2007. The worst of the financial crisis hit in 2008 as the industry reported a record
loss for the year of $34.1 billion. Revenues were $290.5 billion, down 38.7 percent
from 2007. Nearly all revenue lines decreased from 2007 levels, with trading and
investment account losses being the largest (⫺$65.0 billion in 2008).
As quickly as industry profits plunged during the financial crisis, they recovered in 2009. Pretax profits were a record $61.4 billion. Revenues totaled $288.1
billion for the year. Commission and fee income was $49.0 billion of the total,
reflecting improved trading volume. Trading revenues, which had been negative
for six consecutive quarters, grew to $45.3 billion. Industry expenses for 2009 were
$212.4 billion, 33.7 percent below 2008 levels. Of this, interest expense fell to just
$21.9 billion, 82.2 percent below 2008 levels. While still in a fragile state, the industry seemed to be recovering along with the economy.
The U.S. and world economies grew very slowly after the financial crisis. While
interest rates remained at historic lows, concerns about the health of eurozone
economies and the U.S. fiscal cliff kept economic growth at a standstill. Memories
of the financial crisis were still fresh in the minds of investors. Events such as the
May 2010 “flash crash,” the October 2011 collapse of MF Global Holdings, and the
August 2012 trading glitch at Knight Capital caused individual and institutional
investors to limit capital market activity. Industry pretax profits fell to $34.8 billion, $10.6 billion, and $12.4 billion in 2010, 2011, and 2012, respectively.
Balance Sheet
The consolidated balance sheet for the industry is shown in Table 4–7. Note the
current importance of securities trading and underwriting in the consolidated balance sheet of all securities firms. Looking at the asset portfolio, we can see that
reverse repurchase agreements—securities purchased under agreements to resell
(i.e., the broker gives a short-term loan to the repurchase agreement seller)—
accounted for 34.7 percent, receivables from other broker–dealers accounted for
27.9 percent, and long positions in securities and commodities accounted for
23.6 percent of assets. Because of the extent to which this industry’s balance sheet
consists of financial market securities, the industry is subjected to particularly high
levels of market risk (see Chapter 15) and interest rate risk (see Chapters 8 and 9).
100
Part One
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TABLE 4–7
Assets and
Liabilities of
Broker–Dealers as
of 2012 (in billions
of dollars)
Source: Focus Report,
Office of Economic Analysis,
U.S. Securities and
Exchange Commission, 2013.
www.sec.gov
Percent of
Total Assets
Assets
Cash
Receivables from other broker–dealers
Receivables from customers
Receivables from noncustomers
Long positions in securities and commodities
Securities and investments not readily marketable
Securities purchased under agreements to resell
Exchange membership
Other assets
Total assets
Liabilities
Bank loans payable
Payables to other broker–dealers
Payables to noncustomers
Payables to customers
Short positions in securities and commodities
Securities sold under repurchase agreements
Other nonsubordinated liabilities
Subordinated liabilities
Total liabilities
Capital
Equity capital
Total capital (equity capital and subordinate liabilities)
Number of firms
$ 117.2
1,267.6
192.5
47.0
1,074.6
19.7
1,577.4
0.2
254.1
$4,550.3
2.6%
27.9
4.2
1.0
23.6
0.4
34.7
0.0
5.6
$
45.0
621.1
71.0
681.3
381.6
2,065.6
356.9
121.9
$4,344.4
1.0%
13.6
1.6
15.0
8.4
45.4
2.7
2.7
95.5%
$ 205.9
4.5%
327.8
4,481
7.2%
Further, to the extent that many of these securities are foreign issued securities, FI
managers must also be concerned with foreign exchange risk (see Chapter 13) and
sovereign risk (see Chapter 14).
With respect to liabilities, repurchase agreements were the major source of
funds; these are securities temporarily lent in exchange for cash received. Repurchase agreements—securities sold under agreements to repurchase—amounted to
45.4 percent of total liabilities and equity. The other major sources of funds were
payables to customers, payables to other broker–dealers, and securities and commodities sold short for future delivery. Equity capital amounted to only 4.5 percent of total assets, while total capital (equity capital plus subordinated liabilities)
accounted for 7.2 percent of total assets. These levels are well below those we saw
for depository institutions in Chapter 2 (11.48 percent for commercial banks, 11.89
percent for savings institutions, and 10.35 percent for credit unions). One reason
for lower capital levels is that securities firms’ balance sheets contain mostly tradable (liquid) securities compared with the relatively illiquid loans that constitute a
significant proportion of depository institutions’ asset portfolios. Securities firms
are required to maintain a net worth (capital) to assets ratio in excess of 2 percent
(see Chapter 20).
Chapter 4 Financial Services: Securities Brokerage and Investment Banking
Concept
Questions
101
1. Describe the trend in profitability in the securities industry over the past 10 years.
2. What are the major assets held by broker–dealers?
3. Why do broker–dealers tend to hold less equity capital than do commercial banks
and thrifts?
REGULATION
www.sec.gov
www.finra.org
The primary regulator of the securities industry is the Securities and Exchange
Commission (SEC), established in 1934 largely in response to abuses by securities
firms that many at the time felt were partly responsible for the economic problems in the United States. The primary role of the SEC includes administration
of securities laws, review and evaluation of registrations of new securities offerings (ensuring that all relevant information is revealed to potential investors),
review and evaluation of annual and semiannual reports summarizing the financial status of all publicly held corporations, and the prohibition of any form of
security market manipulation. The National Securities Markets Improvement Act
(NSMIA) of 1996 reaffirmed the significance of the SEC as the primary regulator of
securities firms. According to the NSMIA, states are no longer allowed to require
federally registered securities firms to be registered in a state as well. States are
also now prohibited from requiring registration of securities firms’ transactions
and from imposing substantive requirements on private placements. Prior to the
NSMIA, most securities firms were subject to regulation from the SEC and from
each state in which they operated. While the NSMIA provides that states may
still require securities firms to pay fees and file documents to be submitted to the
SEC, most of the regulatory burden imposed by states has been removed. Thus,
the NSMIA effectively gives the SEC the exclusive regulatory jurisdiction over
securities firms.
The early 2000s saw a reversal of this trend toward the dominance of the SEC,
with states—especially their attorneys general—increasingly intervening through
securities-related investigations. Several highly publicized securities violations
resulted in criminal cases brought against securities law violators by mainly state
and some federal prosecutors. For example, the New York State attorney general
forced Merrill Lynch to pay a $100 million penalty because of allegations that
Merrill Lynch brokers gave investors overly optimistic reports about the stock of
its investment banking clients.
In the spring of 2003 the issue culminated in an agreement between regulators
and 10 of the nation’s largest securities firms to pay a record $1.4 billion in penalties
to settle charges involving investor abuse. The long-awaited settlement centered
on charges that securities firms routinely issued overly optimistic stock research
to investors in order to gain favor with corporate clients and win their investment banking business. The agreement also settled charges that at least two big
firms, Citigroup and Credit Suisse First Boston, improperly allocated initial public
offering (IPO) shares to corporate executives to win banking business from their
firms. The SEC and other regulators, including the Financial Industry Regulatory
Authority (FINRA) and state regulators, unveiled multiple examples of how Wall
Street stock analysts tailored their research reports and ratings to win investment
banking business. The agreement forced brokerage companies to make structural
102
Part One
Introduction
changes in the way they handle research—preventing analysts, for example, from
attending certain investment banking meetings with bankers. The agreement also
required securities firms to have separate reporting and supervisory structures
for their research and banking operations. Additionally, it required that analysts’
pay be tied to the quality and accuracy of their research, rather than the amount of
investment banking business they generate. Table 4–8 lists the 10 firms involved in
the settlement and the penalties assessed.
Subsequent to these investigations, the SEC instituted rules requiring Wall
Street analysts to vouch that their stock picks are not influenced by investment
banking colleagues and that analysts disclose details of their compensation that
would flag investors to any possible conflicts. If evidence surfaces that analysts
have falsely attested to the independence of their work, it could be used to bring
enforcement actions. Violators could face a wide array of sanctions, including
fines and other penalties, such as a suspension or a bar from the securities industry. In addition, the SEC now requires that top officials from all public companies
sign off on financial statements.
Despite all of these changes, in December 2012, Morgan Stanley agreed to pay
$5 million to settle allegations that one of its senior investment bankers tried to
improperly influence research analysts in the days before Facebook went public
in May 2012. Allegations involved in the charge that the senior investment banker
arranged phone calls from Facebook to analysts in a way that favored large investors over small investors and that violated restrictions on investment bankers’ role
in the IPO process.
While the SEC sets the overall regulatory standards for the industry, the Financial Industry Regulatory Authority (FINRA) is involved in the day-to-day regulation of trading practices. The FINRA monitors trading abuses (such as insider
trading) trading rule violations, and securities firms’ capital (solvency) positions.
For example, in January 2013, FINRA announced that it is expanding its oversight
of dark pool trading. Dark pools are trades created by institutional orders away
from central exchanges. The details of the trades are unavailable to the public. As
of 2013, nearly 15 percent of all stock trades in the United States occurred through
dark pools, up from 3 percent in 2007. As more financial trading has occurred in
dark pools, regulators and investors are concerned that firms are placing orders
on exchanges and in dark pools at the same time to move stock prices to their
advantage. FINRA’s expanded oversight is intended to monitor and determine
TABLE 4–8
Securities Firm
Penalties Assessed
for Trading Abuses
Source: Authors’ research,
2004.
Firm
Citigroup
Credit Suisse First Boston
Merrill Lynch
Morgan Stanley
Goldman Sachs
Bear Stearns
J.P. Morgan Chase
Lehman Brothers
UBS Warburg
Piper Jaffray
Penalty ($ millions)
$400
200
200
125
110
80
80
80
80
32
Chapter 4 Financial Services: Securities Brokerage and Investment Banking
103
whether orders placed in dark pools are indeed attempts at moving stock prices.
FINRA also announced that it is increasing its surveillance of high-speed trading
and rapid-fire trading across exchanges.
Also overseeing this industry at the federal level is the U.S. Congress. For
example, along with changes instituted by the SEC, the U.S. Congress passed the
Sarbanes-Oxley Act in July 2002. This act created an independent auditing oversight board under the SEC, increased penalties for corporate wrongdoers, forced
faster and more extensive financial disclosure, and created avenues of recourse
for aggrieved shareholders. The goal of the legislation was to prevent deceptive
accounting and management practices and to bring stability to jittery stock markets battered in the summer of 2002 by corporate governance scandals of Enron,
Global Crossings, Tyco, WorldCom, and others.
More recently, the U.S. Senate Permanent Subcommittee on Investigations was
created with the broad mandate to determine whether any changes are required
in U.S. law to better protect the public. In the spring of 2010, a subcommittee hearing focused on the role of investment banks in contributing to the financial crisis.
Investment banks such as Goldman Sachs bundled toxic mortgages into complex
financial instruments, many of which were rated AAA by credit rating agencies,
and sold them to investors. Goldman Sachs, in an attempt to manage its own risk
on these securities, shorted the mortgage market, setting itself up for gains that
would offset losses on the mortgage securities. The subcommittee brought up evidence and internal Goldman documents that showed Goldman knew the housing
market was on the brink of collapse but continued to sell mortgage-backed securities to investors. All the while, Goldman allegedly bet against the securities it built
and sold with the knowledge that the housing market’s collapse would bring the
firm a sizable payday.
The 2010 Wall Street Reform and Consumer Protection Act, passed in response
to the financial crisis, set forth many changes in the way securities firms and
investment banks are regulated. The bill’s Financial Services Oversight Council
of financial regulators was given oversight of the industry in its charge to identify emerging systemic risks. Also under the act, effective July 21, 2011, the dollar threshold for determining whether an investment advisor must register under
federal or state law increased. Specifically, all advisors with assets under management of less than $100 million must register with state regulators and those with
more than $100 million under management must register with the SEC. Prior to
that date, only advisors with assets under management of less than $25 million
registered with a state regulator. The bill also gave new authority for the Federal
Reserve to supervise all firms that could pose a threat to financial stability and
called for stronger capital and other prudential standards for all financial firms,
and even higher standards for large, interconnected firms. Investment banks also
saw stricter oversight as the bill called for the regulation of securitization markets,
stronger regulation of credit rating agencies, a requirement that issuers and originators retain a financial interest in securitized loans, comprehensive regulation
of all over-the-counter derivatives, and new authority for the Federal Reserve to
oversee payment, clearing, and settlement systems. Finally, the bill gave authority
to the government to resolve nonbank financial institutions whose failure could
have serious systemic effects and revised the Federal Reserve’s emergency lending authority to improve accountability.
One of the most publicized “missteps” by securities firms and investment banks
over the course of the financial crisis was related to executive compensation. Top
104
Part One
Introduction
www.sipc.org
Concept
Questions
executives received millions of dollars in bonuses for taking risks that in some
cases paid off and in others cases left taxpayers to bailout the firms. As a result, the
Obama administration proposed compensation rule changes for all financial institutions. Specifically, the administration called for stronger assurances that compensation committees are independent from senior management. It also proposed
regulations that gave shareholders at all publicly traded companies a nonbinding
vote on executive compensation packages. Finally, at FIs receiving government
support, the administration’s “pay czar,” Kenneth Feinberg, was given a say over
compensation packages given to top executives. While meant to curb what was
seen by many as excessive pay, others argued that these restrictions would make it
difficult to attract and retain talent sufficient to keep domestic FIs on a competitive
footing with their global peers.
Securities firms and investment banks have historically been strongly supportive of efforts to combat money laundering, and the industry has been subject to
federal laws that impose extensive reporting and record-keeping requirements.
However, the USA Patriot Act, passed in response to the September 11 terrorist
attacks, included additional provisions that financial services firms must implement. The new rules, which took effect on October 1, 2003, imposed three requirements on firms in the industry. First, firms must verify the identity of any person
seeking to open an account. Second, firms must maintain records of the information used to verify the person’s identity. Third, firms must determine whether a
person opening an account appears on any list of known or suspected terrorists or
terrorist organizations. The rules are intended to deter money laundering without
imposing undue burdens that would constrain the ability of firms to serve their
customers.
Finally, the Securities Investor Protection Corporation (SIPC) protects investors
against losses of up to $500,000 caused by securities firm failures. This guaranty
fund was created after the passage of the Securities Investor Protection Act in 1970
and is funded with premium contributions from member firms. The fund protects
investor accounts against the possibility of a member broker–dealer not being able
to meet its financial obligations to customers. The fund does not, however, protect
against losses on a customer’s account due to poor investment choices that reduce
the value of a portfolio.
1. What is the major result of the NSMIA?
2. What regulatory changes resulted from the financial crisis?
GLOBAL ISSUES
£ ¥
:$
Much more so than other sectors of the financial institutions industry, securities
firms and investment banks operate globally. Both U.S. and European investment
banks compete for business worldwide. This can be seen in Table 4–3, as three
of the top 5 (and 5 of the top 10) underwriters of global debt and equity are U.S.
investment banks (e.g., J.P. Morgan Chase, Bank of America Merrill Lynch) and
the rest European banks (e.g., Barclays Capital, Credit Suisse). In 2012, in M&A
deals involving U.S. targets, 7 of the top 10 advisors were U.S. investment banks
Chapter 4 Financial Services: Securities Brokerage and Investment Banking
105
(e.g., Morgan Stanley, Goldman Sachs) and 3 were European banks (e.g., Barclays
Capital, Deutsche Bank). Further, U.S. investment banks held 6 of the top 10 spots
on M&A deals in Europe and held five of the top spots on deals in Asia.
As domestic securities trading and underwriting have grown in the 1990s and
2000s, so have foreign securities trading and underwriting. Tables 4–9 and 4–10
show foreign transactions in U.S. securities and U.S. transactions in foreign securities from 1991–2012. For example, foreign investors’ transactions involving U.S.
stocks increased from $211.2 billion in 1991 to $12,037.9 billion in 2008 (an increase of
5,600 percent) before falling to $6,654.0 in 2009, during the financial crisis. As of 2012,
stock transactions had increased to only $7,048.6 billion. Similarly, U.S. investors’
transactions involving stocks listed on foreign exchanges grew from $152.6 billion in
1991 to $5,423.0 billion in 2008 (an increase of 3,454 percent), before falling to $3,228.9
in 2009 and recovering only slightly to $3,455.2 billion in 2012. Table 4–11 reports
the total dollar value of international security offerings from 1995–2012. Over this
period, total offerings increased from $570.5 billion to $6,547.2 billion in 2009, then
decreased to $5,503.5 billion in 2011. Of the amounts in 2011, U.S. security issuers
offered $2,558.2 billion in international markets, up from $184.7 billion in 1995.
One result of the financial crisis in the late 2000s was that large investment
banks around the world became more concerned than ever with capital, liquidity,
and leverage. However, they did not want to lose ground in the global competition for clients. The result was that global investment banks looked for strategic
alliances that would allow them to compete in foreign markets or they exited foreign markets altogether. For example, in 2008, Morgan Stanley, in need of capital
to bolster its balance sheet, sold a 21 percent stake in the firm to Japanese financial
TABLE 4–9
Foreign
Transactions in U.S.
Securities Markets
(in billions of
dollars)
Source: Treasury Bulletin,
U.S. Treasury, various dates.
www.ustreas.gov
TABLE 4–10
U.S. Transactions in
Foreign Securities
Markets (in billions
of dollars)
Source: Treasury Bulletin,
U.S. Treasury, various dates.
www.ustreas.gov
Year
1991
1995
2000
2006
2007
2008
2009
2010
2011
2012
Corporate Stock Transactions
$
211.2
451.7
3,605.2
6,868.6
10,639.3
12,037.9
6,654.0
6,747.2
7,720.3
7,048.6
Corporate Bond Transactions
$
85.9
168.1
479.5
1,678.5
1,913.3
1,467.0
1,189.4
971.2
996.1
937.6
Year
Corporate Stock Transactions
Corporate Bond Transactions
1991
1995
2000
2006
2007
2008
2009
2010
2011
2012
$ 152.6
395.8
1,815.3
3,742.6
5,311.1
5,423.0
3,228.9
3,734.3
4,040.2
3,455.2
$ 345.1
927.9
963.0
2,024.2
3,105.7
2,217.7
2,079.4
3,704.8
3,583.4
3,686.8
106
Part One
Introduction
TABLE 4–11 Value of International Security Offerings (in billions of dollars)
Source: Quarterly Review: International Banking and Financial Market Developments, Bank for International Settlements, various issues. www.bis.org
1995
2001
2002
2005
2006
2007
2008
2009
2010
2011
2012*
Total International Offerings
Floating-rate debt $103.0 $ 642.7 $ 603.3 $1,470.7 $2,063.9 $2,008.1 $2,249.9 $1,451.6 $1,158.8 $1,252.5 $ 675.1
Straight debt
394.8 1,590.3 1,454.6 2,323.9 2,763.9 3,301.6 3,040.9 4,261.7 3,689.9 3,698.1 2,673.3
Convertible debt
18.1
72.2
42.7
41.7
51.2
100.9
74.6
100.7
91.3
70.3
45.2
Equity
54.6
149.4
102.3
307.5
371.3
499.1
392.2
733.2
701.1
482.6
352.2
Total offerings
$570.5 $2,454.6 $2,202.9 $4,143.8 $5,250.3 $5,909.7 $5,802.6 $6,547.2 $5,641.1 $5,503.5 $3,745.8
International Offerings by U.S. Issuers
Floating-rate debt $ 50.9 $ 262.3 $ 214.4 $ 602.4 $ 708.8 $ 653.3 $ 509.4 $ 537.2 $ 296.3 $ 441.1 $ 182.8
Straight debt
115.3
836.1
755.0 1,454.0 1,202.0 1,482.0 1,294.8 1,866.1 2,002.6 1,899.7 1,310.1
Convertible debt
8.5
32.9
16.5
42.8
17.4
100.9
74.6
56.8
63.8
39.0
24.0
Equity
10.0
24.8
1.2
5.7
16.3
12.9
99.0
245.5
212.3
178.4
168.4
Total offerings
$184.7 $1,156.1 $ 987.1 $2,104.9 $1,944.5 $2,249.1 $1,977.8 $2,705.6 $2,575.0 $2,558.2 $1,685.3
* Through three quarters.
institution, Mitsubishi UFJ. In March 2009, the two announced plans to form a
joint venture that combined each firm’s Japan-based securities business. Morgan
Stanley took 40 percent ownership and managerial control of the institutional
business, and Mitsubishi took the remaining ownership and control of the retail
operations. This kind of arrangement provides U.S.-based investment banks with
a foothold alongside a domestic firm in the foreign market. In contrast to the type
of strategic alliance as that between Morgan Stanley and Mitsubishi UFJ is Citigroup, which during the financial crisis had to deal with growing U.S. government
ownership, a deteriorating credit environment, and an unwieldy structure. Rather
than try to compete globally in this environment, Citigroup decided to abandon
several foreign markets. Citigroup sold its Japanese domestic securities unit, and
its Japanese asset management unit, Nikko Asset Management, to subsidiaries of
Sumitomo Mitsui Financial Group. It also sold NikkoCiti Trust and Banking Corp.
to Nomura Trust & Banking Co. Moves such as the sale of international properties,
originally acquired to allow the investment bank to expand globally, will likely
continue to play a part in the reshaping of the global investment banking industry.
One of the more grievous actions by some global investment banks during the
financial crisis was the manipulation of the LIBOR (London Interbank Offered Rate)
interest rate. LIBOR is the interest rate at which banks can borrow from each other.
It is also used to price, among other things, mortgage and business loans and derivative securities. LIBOR is the average of the interest rates submitted by major banks
in the United States, Europe, and the United Kingdom in a variety of major currencies such as the dollar, euro, and yen. The scandal arose when it was discovered
that banks had been manipulating the LIBOR rate so as to make either profits on its
derivative positions (such as interest rate swaps) or to make the bank look stronger
for reputational reasons. It is estimated that the banks involved made at least
$75 billion on the manipulations. The After the Crisis box summarizes the allegations that several large banks tried to manipulate the LIBOR rate during the financial crisis. The scandal became widely public in June 2012 when British investment
bank Barclays agreed to pay $450 million to settle allegations by U.S. and British
authorities that some of its traders attempted to manipulate LIBOR rates to increase
the bank’s profits and reduce concerns about its stability during the financial crisis.
Chapter 4 Financial Services: Securities Brokerage and Investment Banking
After the Crisis
107
Traders Manipulated Key Rate,
Bank Says
A group of traders and brokers successfully managed to manipulate an interest rate that affects
loans around the world, one of the banks being
investigated has told regulators. In a court filing in
Ottawa, Canada’s Competition Bureau said a bank
it didn’t identify has told the agency’s investigators
that people involved in the alleged scheme “were
able to move” interest rates . . .
The Canadian regulator also sets out clearly for
the first time how its investigators believe bank
employees may have managed to game a system
used to set costs for financial products around the
world, with the alleged aim of increasing their trading profits. The yen London Interbank Offered Rate,
or Libor, is calculated by Thomson Reuters under the
auspices of the British Bankers’ Association and is
based on data submitted daily by a 16-bank panel.
Around 11 a.m. London time every day, each bank
submits estimates of what rates it would pay to borrow from other banks for different time periods. The
top four and bottom four quotes are then discarded,
and Libor is calculated using an average of the
middle eight quotes. The Canadian watchdog said
lawyers acting for the cooperating bank had told it
that traders at six banks on the yen Libor panel…
“entered into agreements to submit artificially high
or artificially low” quotes, according to the court
documents. The traders used emails and instant messages to tell each other whether they wanted “to
see a higher or lower yen Libor [rate] to aid their
trading position(s),” according to a court filing. Each
of the traders would then “communicate internally”
with the person at their bank who was responsible
for submitting the Libor quote, before letting each
other know if this attempt to influence the quote
had worked. “Not all attempts to affect Libor submissions were successful,” the regulator said in the
court filing.
The Canadian regulator said it is investigating
whether the traders also “conspired” with individuals at interdealer broker firms, according to
the documents. These brokers act as go-betweens
for the different banks, advising them on the interbank borrowing rates on which Libor quotes are
based. The brokers were asked by the traders “to
use their influence with yen Libor submitters to
affect what rates were submitted by other yen Libor
panel banks,” including banks that were part of the
alleged conspiracy, according to a court filing . . .
The BBA has made some tweaks to how Libor
is calculated, such as increasing the size of the U.S.
dollar panel, since concerns about the integrity of
the system were raised following the financial crisis.
But the fundamental approach of calculating rates
based on estimates submitted by banks remains
unchanged, despite the intensifying global probe.
Source: The Wall Street Journal, February 17, 2012, by Jean
Eaglesham, Paul Vieira, and David Enrich. Reprinted by
permission of The Wall Street Journal. © 2012 Dow Jones &
Company, Inc. All Rights Reserved Worldwide. www.wsj.com
Concerns were also raised about the failure of British and U.S. regulators to stop
the manipulation of LIBOR when there was evidence that both were aware of it. In
July 2012, a former trader stated that LIBOR manipulation had been occurring since
at least 1991. In July 2012, the Federal Reserve Bank of New York released documents
dated as far back as 2007 showing that they knew that banks were misreporting their
borrowing costs when setting LIBOR. Yet, no action was taken. Similarly, documents
from the Bank of England indicated that the bank knew as early as November 2007
that the LIBOR rate was being manipulated. It was not until June 2012 that Barclays
became the first bank to agree to settle LIBOR manipulation allegations. In December 2012, UBS agreed to pay about $1.5 billion to settle charges that it manipulated
LIBOR. In February 2013, the Royal Bank of Scotland also decided to settle at a cost of
$610 million. Also in early 2013, Deutsche Bank stated that it had set aside money to
cover potential fines associated with its role in the manipulation of the LIBOR.
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Part One
Introduction
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Concept
Questions
1. What have been the trends in foreign transactions in U.S. securities and U.S. transactions in foreign securities in the 1990s and 2000s?
2. What have been the trends in international securities offerings in the late 1990s and
2000s?
3. Why do foreign banks operating in the United States compete with both U.S. commercial banks and investment banks?
Summary
This chapter presented an overview of security firms (which offer largely retail
services to investors) and investment banking firms (which offer largely wholesale services to corporate customers). Firms in this industry assist in getting new
issues of debt and equity to the markets. Additionally, this industry facilitates
trading and market making of securities after they are issued as well as corporate mergers and restructurings. We looked at the structure of the industry and
changes in the degree of concentration in firm size in the industry over the last
decade. We also analyzed balance sheet information which highlighted the major
assets and liabilities of firms in the industry. Overall, the industry is in a period
of consolidation and globalization as the array and scope of its activities expand.
Questions
and Problems
1. Explain how securities firms differ from investment banks. In what ways are
they financial intermediaries?
2. In what ways have changes in the investment banking industry mirrored
changes in the commercial banking industry?
3. What are the different types of firms in the securities industry and how does
each type differ from the others?
4. What are the key activity areas for investment banks and securities firms? How
does each activity area assist in the generation of profits and what are the major
risks for each area?
5. What is the difference between an IPO and a secondary issue?
6. What is the difference between a private placement and a public offering?
7. What are the risk implications to an investment bank from underwriting on a
best-efforts basis versus a firm commitment basis? If you operated a company
issuing stock for the first time, which type of underwriting would you prefer?
Why? What factors might cause you to choose the alternative?
8. An investment bank agrees to underwrite an issue of 15 million shares of stock
for Looney Landscaping Corp.
a. If the investment bank underwrites the stock on a firm commitment basis, it
agrees to pay $12.50 per share to Looney Landscaping Corp. for the 15 million
shares of stock. It can then sell those shares to the public for $13.25 per share.
How much money does Looney receive? What is the profit to the investment
bank? If the investment bank can sell the shares for only $11.95, how much
money does Looney receive? What is the profit to the investment bank?
b. Suppose, instead, that the investment bank agrees to underwrite the 15 million shares on a best-efforts basis. The investment bank is able to sell 13.6 million shares for $12.50 per share, and it charges Looney Landscaping Corp.
$0.275 per share sold. How much money does Looney receive? What is the
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
109
profit to the investment bank? If the investment bank can sell the shares for
only $11.95, how much money does Looney receive? What is the profit to
the investment bank?
An investment bank agrees to underwrite a $500 million, 10-year, 8 percent
semiannual bond issue for KDO Corporation on a firm commitment basis.
The investment bank pays KDO on Thursday and plans to begin a public sale
on Friday. What type of interest rate movement does the investment bank fear
while holding these securities? If interest rates rise 0.05 percent, or five basis
points, overnight, what will be the impact on the profits of the investment
bank? What if the market interest rate falls five basis points?
An investment bank pays $23.50 per share for 4 million shares of JCN Company. It then sells those shares to the public for $25 per share. How much
money does JCN receive? What is the profit to the investment bank? What is
the stock price of JCN?
XYZ Inc. has issued 10 million new shares of stock. An investment bank agrees
to underwrite these shares on a best-efforts basis. The investment bank is able
to sell 8.4 million shares for $27 per share, and it charges XYZ $0.675 per share
sold. How much money does XYZ receive? What is the profit to the investment bank? What is the stock price of XYZ?
What is venture capital?
What are the different types of venture capital firms? How do institutional
venture capital firms differ from angel venture capital firms?
What are the advantages and disadvantages to a new or small firm of getting
capital funding from a venture capital firm?
How do agency transactions differ from principal transactions for market
makers?
One of the major activity areas of securities firms is trading.
a. What is the difference between pure arbitrage and risk arbitrage?
b. What is the difference between position trading and program trading?
If an investor observes that the price of a stock trading in one exchange is
different from the price in another exchange, what form of arbitrage is applicable, and how can the investor participate in that arbitrage?
An investor notices that an ounce of gold is priced at $1,518 in London and
$1,525 in New York.
a. What action could the investor take to try to profit from the price discrepancy?
b. Under which of the four trading activities would this action be classified?
c. If the investor is correct in identifying the discrepancy, what pattern should
the two prices take in the short term?
d. What may be some impediments to the success of this transaction?
What three factors are given credit for the steady decline in brokerage commissions as a percentage of total revenues over the period beginning in 1977
and ending in 1991?
What factors are given credit for the resurgence of profitability in the securities industry beginning in 1991? Are firms that trade in fixed-income securities more or less likely to have volatile profits? Why?
Using Table 4–6, which type of security accounts for most underwriting in the
United States? Which is likely to be more costly to underwrite: corporate debt
or equity? Why?
How did the financial crisis affect the performance of securities firms and
investment banks?
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Chapter 4 Financial Services: Securities Brokerage and Investment Banking
110
Part One
Introduction
23. How do the operating activities, and thus the balance sheet structures, of
securities firms differ from the operating activities of depository institutions?
How are the balance sheet structures of securities firms similar to depository
institutions?
24. Based on the data in Table 4–7, what were the largest single asset and the
largest single liability of securities firms in 2012? Are these asset and liability
categories related? Exactly how does a repurchase agreement work?
25. How did the National Securities Markets Improvement Act of 1996 (NSMIA)
change the regulatory structure of the securities industry?
26. Identify the major regulatory organizations that are involved in the daily
operations of the investment securities industry, and explain their role in providing smoothly operating markets.
27. What are the three requirements of the USA Patriot Act that financial service
firms must implement after October 1, 2003?
Web Questions
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28. Go to the Securities Industry and Financial Markets Association website at
www.sifma.org and find the most recent data on U.S. corporate underwriting activity using the following steps. Click on “Research.” Click “Statistics
and Data.” Click on “US Key Stats.” This will download an Excel file to your
computer that contains the relevant data, on the page “Corporate.” How has
the distribution of underwriting activity changed since 2012, as reported in
Table 4–6?
29. Go to the U.S. Treasury website at www.ustreas.gov and find the most recent
data on foreign transactions in U.S. securities and U.S. transactions in foreign
securities using the following steps. Under “Bureaus,” click on “Financial
Management Services.” Under “Publications,” click on “Treasury Bulletin.”
Click on “Capital Movements Tables (Section IV).” This will download a file
onto your computer that will contain the most recent information on foreign
transactions. How have these number changed since 2012, as reported in
Tables 4–9 and 4–10?
Chapter Five
Financial Services:
Mutual Funds
and Hedge Funds
INTRODUCTION
Mutual funds and hedge funds are financial institutions that pool the financial
resources of individuals and companies and invest in diversified portfolios of
assets. An open-ended mutual fund (the major type of mutual fund) continuously
stands ready to sell new shares to investors and to redeem outstanding shares on
demand at their fair market value. Thus, these funds provide opportunities for
small investors to invest in financial securities and diversify risk. Mutual funds
are also able to generate greater economies of scale by incurring lower transaction
costs and commissions than are incurred when individual investors buy securities
directly. As a result of the tremendous increase in the market value of financial
assets, such as equities, in the 1990s (for example, the S&P 500 index saw a return
of more than 25 percent in 1997 and 1998) and the relatively low-cost opportunity
mutual funds provide to investors (particularly small investors) who want to hold
such assets (through either direct mutual fund purchases or contributions to retirement funds sponsored by employers and managed by mutual funds), the mutual
fund industry boomed in size and customers in the 1990s. The early 2000s and a
slowdown in the U.S. economy brought an end to such a rapid pace of growth
and the more severe financial crisis of 2008–09 resulted in the largest ever drop in
the value of industry assets. During 2008, mutual fund losses on investments in
financial securities and liquidation of mutual fund shares by investors resulted
in a drop in industry assets of $2.4 trillion (or 20 percent). Further, allegations of
trading abuses resulted in a loss of confidence in several mutual fund managers.
Despite these issues, in 2012 more than 7,000 different stock and bond mutual
companies held total assets of $10.26 trillion. If we add money market mutual
funds, the number of funds rises to more than 7,600 and the 2012 value of assets
under management rises to $12.87 trillion.
Hedge funds are a type of investment pool that solicit funds from (wealthy) individuals and other investors (e.g., commercial banks) and invest these funds on their
behalf. Hedge funds are similar to mutual funds in that they are pooled investment
vehicles that accept investors’ money and generally invest it on a collective basis.
Investments in hedge funds, however, are restricted to more wealthy clients.
111
112
Part One
Introduction
In this chapter we first provide an overview of the services offered by mutual
funds and highlight their rapid growth over the last twenty-five years. We look at
the size, structure, and composition of the industry, highlighting historical trends
in the industry, the different types of mutual funds, mutual fund objectives, investor returns from mutual fund ownership, and mutual fund costs. We also look
at the industry’s balance sheets and recent trends, the regulations and regulators
governing the industry, and global issues for this industry. We then discuss investment pools organized as hedge funds. Because hedge funds limit investors to only
the wealthiest individuals, they are examined separately from mutual funds discussed elsewhere in the chapter. Another difference between mutual funds and
hedge funds is that, prior to 2010, hedge funds were generally unregulated. However, as a result of some very publicized hedge fund failures and near failures (the
result of fraud by fund managers, e.g., Bernard L. Madoff Investment Securities
and the financial crisis, e.g., Bear Stearns High Grade Structured Credit Strategies
Fund), in 2010 federal regulators increased the oversight of hedge funds. Specifically, regulations now require that hedge funds with assets under management
exceeding some threshold should be required to register with the SEC under the
Investment Advisers Act of 1940 in a similar fashion to that required for mutual
funds. Similarly, fund advisors are required to report financial information on the
funds they manage that is sufficient to assess whether any fund poses a threat to
the financial system.
SIZE, STRUCTURE, AND COMPOSITION
OF THE MUTUAL FUND INDUSTRY
Historical Trends
The first mutual fund was founded in Boston in 1924. The industry grew very
slowly at first; by 1970, 361 funds held about $50 billion in assets. Since then the
number of mutual funds and the asset size of the industry have increased dramatically. This growth is attributed to the advent of money market mutual funds in 1972
(as investors looked for ways to earn market rates on short-term funds when bank
deposit rates were constrained by regulatory ceilings), to tax-exempt money market mutual funds first established in 1979, and to an explosion of special-purpose
equity, bond, emerging market, and derivative funds (as capital market values
soared in the 1990s). Table 5–1 documents the tremendous increase from 1940
though 2007 of mutual funds. For example, total assets invested in mutual funds
grew from $0.5 billion in 1940 to $12,001.46 billion in 2007 (of which $8,916.5 billion
was invested in long-term funds). In addition, the number of mutual fund accounts
increased from 296,000 in 1940 to 292.6 million in 2007 (253.5 million of which were
long-term fund accounts), and the number of mutual funds increased from 68 in
1940 to 8,026 in 2007. The majority of this growth occurred during the bull market
run in the 1990s (total assets in 1990 were $1,065.2 billion). The financial crisis and
the collapse in stock and other security prices produced a sharp drop in mutual
fund activity. At the end of 2008, total assets fell to $9,603.6 billion and the number
of accounts to 264.6 million (of this, $5,771.3 billion and 226.5 million accounts were
long-term funds). Investor demand for certain types of mutual funds plummeted,
driven in large part by deteriorating financial market conditions. Equity funds
suffered substantial outflows, while the inflow to U.S. government money market funds reached record highs. As the economy recovered starting in 2009, so did
Chapter 5
TABLE 5–1
Financial Services: Mutual Funds and Hedge Funds
113
Growth of Mutual Fund Industry, 1940–2012
Sources: Investment Company Institute, 2006 Investment Company Fact Book (Washington, DC: Investment Company Institute, May 2006) and Trends in Mutual
Fund Investing, various issues. www.ici.org
Year
Total Net
Assets (billions)
Gross Sales
(billions)
Redemptions
(billions)
Net Sales
(billions)
Accounts
(thousands)
Number of
Funds
2012
2010
2009
2008
2007
2005
2000
1995
1990
1980
1970
1960
1950
1940
$13,045.2
11,831.9
11,113.0
9,603.6
12,001.5
8,904.8
6,964.6
2,811.3
1,065.2
134.8
47.6
17.0
2.5
0.5
$17,020.90
18,207.5
20,680.0
26,346.7
23,471.7
14,042.5
11,109.4
3,600.6
1,564.8
247.4
4.6
2.1
0.5
N/A
$16,618.7
18,319.1
20,680.2
25,725.8
22,353.4
13,648.4
10,586.6
3,314.9
1,470.8
216.1
3.0
0.8
0.3
N/A
$402.2
⫺111.6
⫺0.2
620.9
1,118.3
394.1
522.8
285.7
94.0
31.3
1.6
1.3
0.2
N/A
264,131
291,299
269,450
264,599
292,555
275,479
244,706
131,219
61,948
12,088
10,690
4,898
939
296
7,596
7,580
7,684
8,022
8,026
7,975
8,155
5,725
3,079
564
361
161
98
68
Note: Data include money market funds. Institute “gross sales” figures include the proceeds of initial fund underwritings prior to 1970.
assets invested in mutual funds, growing to $11,113.0 billion by the end of the year
and to $13,045.2 billion in 2012 (finally surpassing 2007 levels). Of this, $10,351.7
billion were invested in long-term funds.
Additionally, growth has been the result of the rise in retirement funds under
management by mutual funds. The retirement fund market has increased from
$4 trillion in 1990 to almost $20.0 trillion in 2012. Mutual funds manage approximately one-quarter of this market and have experienced the growth along with it.
Many of these retirement funds are institutional funds. Institutional funds are
mutual funds that manage retirement plans for an institution’s employees. Institutions arrange these retirement (mutual) funds for the benefit of their members.
Wealthy individuals also often use institutional funds. In total, about 80 percent of
all retirement plan investments are in institutional funds. Institutional funds are
managed by the same companies that run mutual funds: banks, insurance companies, brokers, and mutual fund advisory companies. Costs of institutional funds
are very low because there are no additional distribution fees and because the
retirement plan can use its bargaining power to get the best deals. Unlike the case
with traditional mutual funds, retirement plan sponsors can set out how much
risk an institutional fund can take in trying to beat the market.
As can be seen in Figure 5–1, in terms of asset size, the mutual fund industry is
larger than the insurance industry, but smaller than the commercial banking industry. This makes mutual funds the second most important FI group in the United
States as measured by asset size. The tremendous growth in this area of FI services has not gone unnoticed by commercial banks as they have sought to directly
compete by either buying existing mutual fund groups or managing mutual fund
assets for a fee. Banks’ share of all mutual fund assets managed was about 7 percent in 2012. Much of this growth has occurred through banks buying mutual fund
companies, for example, Mellon buying Dreyfus, as well as converting internally
114
Part One
Introduction
FIGURE 5–1
Assets of Major
Financial
Intermediaries,
1990, 2007, and
2012 (in trillions of
dollars)
Source: Federal Reserve
Board, “Flow of Fund
Accounts,” various years.
www.federalreserve.gov
14.8
15
14
13
12.4
11.8
12
10.9
11
10
9
8
7.0
7
6.3
6.4
6.6
1990
2007
2012
6
5
4.5
4
3.23.1
3
1.9
2
1.9
1.6
1.6
1.1
1
0
0.7
Depository
institutions
Mutual
Funds
MutualFunds
Funds
Mutual
Mutual
funds
Insurance
companies
Private
Pention Fund
pension
funds
State and local
government
pension funds
0.6
Finance
companies
managed trust funds into open-end mutual funds. Insurance companies are also
beginning to enter this booming industry. In March 2001, for example, State Farm
began offering a family of 10 mutual funds nationwide. The funds are available
from more than 9,000 registered State Farm agents, on the Internet, or by application sent in response to phone requests made to a toll-free number. As of 2012,
insurance companies managed 5 percent of the mutual fund industry’s assets.
Low barriers to entry in the U.S. mutual fund industry have allowed new
entrants to offer funds to compete for investor attention and has kept the industry
from being increasingly concentrated. As a result, the share of industry assets held
by the largest mutual fund sponsors has changed little since 1990. For example,
the largest 25 companies that sponsor mutual funds managed 73 percent of the
industry’s assets in 2012, compared to 25 percent in 1990. The composition of the
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
115
list of the 25 largest fund sponsors, however, has changed, with 12 of the largest
fund companies in 2012 not among the largest in 1990.
Different Types of Mutual Funds
equity funds
Funds that contain
common and preferred stock securities.
bond funds
Funds that contain fixed-income
capital market debt
securities.
hybrid funds
Funds that contain
bond and stock
securities.
money market
mutual funds
Funds that contain
various mixtures
of money market
securities.
The mutual fund industry is usually divided into two sectors: short-term funds and
long-term funds. Long-term funds include equity funds (comprised of common and
preferred stock securities), bond funds (comprised of fixed-income securities with a
maturity of longer than one year), and hybrid funds (comprised of both bond and
stock securities). Short-term funds include taxable money market mutual funds
(MMMFs) and tax-exempt money market mutual funds. Table 5–2 shows how the
mix of stock, bond, hybrid, and money market fund assets changed between 1980
and 2012. As can be seen, there was a strong trend toward investing in equity mutual
funds, reflecting the rise in share values during the 1990s. As a result, in 1999, 74.3 percent of all mutual fund assets were in long-term funds while the remaining funds, or
25.7 percent, were in money market mutual funds. The proportion invested in longterm versus short-term funds can vary considerably over time. For example, the share
of money market funds was 44.8 percent in 1990 compared to 25.7 percent in 1999.
The decline in the growth rate of short-term funds and the increase in the growth rate
of long-term funds reflect the increase in equity returns during the period 1992–99
and the generally low level of short-term interest rates over the period. Notice that in
the early 2000s, as interest rates rose, the U.S. economy declined, and equity returns
fell, the growth in money market funds outpaced the growth in long-term funds. In
2002, the share of long-term funds fell to 62.1 percent and money market funds grew
to 37.9 percent. However, in the mid-2000s, as the U.S. economy grew and stock values increased, the share of long-term funds grew (to 72.1 percent of all funds in 2007),
while money market funds decreased (to 27.9 percent in 2007).
The 2008–2009 financial crisis and the collapse in stock prices produced a
sharp drop in long-term mutual fund activity. Equity funds suffered substantial
outflows, while inflows to U.S. government money market funds reached record
highs. At the end of 2008, the share of long-term equity and bond funds plunged to
59.1 percent of all funds, while money market funds increased to 40.9 percent. As
discussed below, part of the move to money market funds was the fact that during
the worst of the financial crisis, the U.S. Treasury extended government insurance
to all money market mutual fund accounts on a temporary basis. In 2009, as the
economy and the stock market recovered, the share of long-term equity and bond
funds increased back to 68.1 percent of all funds, while money market funds
fell to 31.9 percent. By 2012, the share of long-term equity and bond funds was
78.7 percent of all funds, while money market funds decreased to 21.3 percent.
Money market mutual funds provide an alternative investment to interestbearing deposits at commercial banks, which may explain the growth in MMMFs
in the 1980s and late 1990s, when the spread earned on MMMF investments relative to deposits was mostly positive (see Figure 5–2). Both investments are relatively safe and earn short-term returns. The major difference between the two is
that interest-bearing deposits (below $250,000 in size) are fully insured by the FDIC
but due to bank regulatory costs (such as reserve requirements, capital requirements, and deposit insurance premiums) generally offer lower returns than do
noninsured MMMFs.1 Thus, the net gain in switching to MMMFs is higher returns
1
Some mutual funds are covered by private insurance and/or by implicit or explicit guarantees from
mutual fund management companies.
116
TABLE 5–2
Growth in Long-Term versus Short-Term Mutual Funds, 1980–2012 (in billions of dollars)
Source: Federal Reserve Bulletin, “Flow of Fund Accounts,” various issues. www.federalreserve.gov
1980
1990
1999
2000
2002
2004
2007
2008
2009
2012
Panel A: Equity, Hybrid, and Bond Mutual Funds
Holdings at market value
$61.8 $608.4 $4,538.5 $4,433.1 $3,638.4 $5,436.3 $7,829.0 $5,435.3 $6,961.6 $9,262.4
Household sector
52.1 511.6
2,894.9
2,704.3
2,218.3
3,417.6
4,832.0
3,442.6
4,161.1
5,542.9
Nonfinancial corporate business
1.5
9.7
127.0
121.9
95.8
140.5
217.5
143.3
161.9
171.4
State and local governments
0.0
4.8
33.4
30.8
24.3
27.5
34.5
29.8
37.5
37.1
Commercial banking
0.0
1.9
12.4
15.0
19.6
18.1
29.6
19.6
46.1
52.8
Credit unions
0.0
1.4
2.5
2.2
3.5
3.1
2.1
2.0
1.3
2.1
Insurance companies
1.1
30.7
101.4
99.9
79.6
119.6
195.2
125.4
146.1
165.1
Private pension funds
7.1
40.5
1,056.5
1,131.7
931.9
1,278.2
1,848.2
1,229.5
1,817.3
2,370.5
State and local government retirement funds
0.0
7.8
140.9
178.3
167.4
235.9
296.4
181.1
226.7
274.6
Rest of world
0.0
0.0
169.5
149.0
98.0
195.8
373.5
262.0
363.6
645.9
Panel B: Money Market Mutual Funds
Total assets
$76.4 $493.3 $1,579.6 $1,812.1 $2,223.9 $1,879.8 $3,033.1 $3,757.3 $3,258.3 $2,506.9
Household sector
64.3 389.4
774.2
937.3
1,071.7
904.1
1,346.6
1,581.9
1,313.1
1,044.5
Nonfinancial corporate business
7.0
19.7
196.8
213.9
319.7
299.6
548.5
710.6
641.7
427.2
Nonfinancial noncorporate business
0.0
6.7
40.7
49.4
61.3
66.5
74.3
75.4
73.7
70.6
State and local governments
0.0
0.0
51.2
53.9
58.7
78.6
116.6
113.3
122.0
126.5
Insurance companies
1.9
19.1
19.4
23.1
27.6
30.5
42.3
71.9
63.3
55.9
Private pension funds
2.6
17.8
76.9
81.1
84.5
84.9
93.5
95.7
96.4
96.1
State and local government retirement funds
0.0
2.8
11.8
13.2
15.5
11.6
12.4
14.3
14.3
15.1
Funding corporations
0.6
36.6
400.5
429.0
568.6
381.1
752.8
1,024.5
857.1
607.5
Rest of world
0.0
1.2
8.1
11.2
16.3
22.9
46.0
69.7
76.9
63.5
Chapter 5
FIGURE 5–2
Financial Services: Mutual Funds and Hedge Funds
117
Interest Rate Spread and Net New Cash Flow to Retail Money Market Funds, 1985–2012
Source: Investment Company Institute, Investment Company Fact Book (Washington, DC: Investment Company Institute, various issues). www.ici.org
Percent
5
Percent of total assets
4
Interest rate spread
4
3
3
2
2
1
1
0
0
−1
−1
Net new cash flow
−2
−3
−2
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
−3
Note: Net new cash flow is a percentage of retail money market fund assets and is shown as a six-month moving average. The interest rate spread is the
difference between the taxable money market fund yield and the average interest rate on savings deposits; the series is plotted with a six-month lag.
in exchange for the loss of deposit insurance coverage. Many investors appeared
willing to give up insurance coverage to obtain additional returns in the 1980s and
late 1990s (through 2001).
An exception occurred during the financial crisis of 2008–09. In September 2008,
Reserve Primary Fund a large and reputedly conservative money market fund,
had holdings of $785 million in commercial paper issued by Lehman Brothers. As
a result of Lehman’s failure, shares in Reserve Primary Fund “broke the buck” (i.e.,
fell below $1), meaning that its investors lost part of their principal investment. This
was the first ever incidence of a share price dipping below a dollar for any money
market mutual fund open to the general public. This type of fund had built a reputation for safe investment. Hence, exposure to Lehman’s failure scared investors,
leading to a broad run on all money market mutual funds. Within a few days more
than $200 billion had flowed out of these funds. The U.S. Treasury stopped the run
by extending government insurance to all money market mutual fund accounts
held in participating money market funds as of the close of business on September
19, 2008. The insurance coverage lasted for one year (through September 18, 2009).
As seen in Figure 5–2, this action is associated with a change in trend from net outflows to net inflows of funds into money market mutual funds.
Table 5–3 reports the growth in the mutual fund industry based on the number
of funds in existense from 1980 through 2012. All categories of funds have generally increased in number in this time period, from a total of 564 in 1980 to 8,026
in 2007. Tax-exempt money market funds first became available in 1979. This was
118
Part One
Introduction
TABLE 5–3
Number of Mutual
Funds, 1980–2012
Source: Investment Company Institute, Investment
Company Fact Book, various
years (Washington DC:
Investment Company Institute). www.ici.org
Year
Equity
Hybrid
Bond
Taxable
Money
Market
1980*
1990
2000
2002
2007
2008
2009
2010
2011
2012
288
1,099
4,385
4,747
4,763
4,802
4,616
4,547
4,581
4,527
N/A
193
523
473
489
483
471
475
495
532
170
1,046
2,208
2,035
1,969
1,954
1,893
1,906
1,929
1,959
96
506
703
679
546
534
476
442
431
405
Tax-Exempt
Money
Market
Total
10
235
336
310
259
249
228
210
201
189
564
3,079
8,155
8,244
8,026
8,022
7,684
7,580
7,637
7,612
* The definition of equity, hybrid, and bond funds was reclassified in 1984. Thus, 1980 data are not directly comparable to
data for other years.
the major reason for their relatively small number (10 funds) in 1980. Also, the
number of equity funds has boomed, mainly in the 1990s. Equity funds numbered
4,763 in 2007, up from 1,099 in 1990, while bond funds numbered 1,969 in 2007,
up from 1,046 in 1990. But again, the 2008–09 financial crisis and the collapse in
financial markets produced a significant drop in the number of mutual funds. The
number of equity funds fell to 4,616 and bond funds fell to 1,893 by the end of
2009. The total number of funds dropped below 8,000 for the first time since 1999.
In terms of the number of funds, the industry has still not recovered from the crisis. As of 2012, the number of equity funds had fallen to 4,527 and the total number of mutual funds stood at 7,612.
Notice that in Table 5–2 households (i.e., small investors) own the majority of both
long- and short-term funds: 59.8 percent for long-term mutual funds and 41.7 percent for short-term mutual funds in 2012. This is to be expected, given that the rationale for the existence of mutual funds is to achieve superior diversification through
fund and risk pooling compared to what individual small investors can achieve on
their own. Consider that wholesale CDs sell in minimum denominations of $100,000
each and often pay higher interest rates than passbook savings accounts or small
time deposits offered by depository institutions. By pooling funds in a money market mutual fund, small investors can gain access to wholesale money markets and
instruments and, therefore, to potentially higher interest rates and returns.
Internet Exercise
Go to the Federal Reserve Board’s website at www.federalreserve.gov. Find the latest figures for the dollar value of money market and long-term mutual funds and the distribution of
mutual fund investment by ownership using the following steps. Click on “Flow of Funds—
Z.1.” Click on the most recent date. Click on “Level tables.” This downloads a file onto your
computer that contains the relevant data, in Tables L.206 and L.214.
As of 2012, 53.8 million (44.4 percent of) U.S. households owned mutual funds.
This was down from 56.3 million (52 percent) in 2001. Table 5–4 lists some characteristics of household mutual fund owners as of 2012 and 1995. Most are long-term
owners, with 38 percent making their first purchases before 1990. While mutual fund
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
TABLE 5–4
Selected
Characteristics of
Household Owners
of Mutual Funds*
Source: Investment
Company Institute, Profile
of Mutual Fund Shareholders,
various years (Washington,
DC: Investment Company
Institute). www.ici.org
119
2012
1995
51 years
$ 80,000
$200,000
44 years
$ 60,000
$ 50,000
75.0
72.0
48.0
71.0
80.0
58.0
48.0
36.0
69.0
17.0
68.0
28.3
$120,000
4
$ 18,000
3
79
50
44
66
73
49
N/A
52
Demographic Characteristics:
Median age
Median household income
Median household financial assets
Percent:
Married or living with a partner
Employed
Four-year college degree or more
Household financial assets invested in
mutual funds
Owning fund inside employer-sponsored
retirement funds
Owning fund outside employer-sponsored
retirement funds
Mutual Fund Ownership Characteristics:
Median mutual fund assets
Median number of funds owned
Fund Types Owned (percent):
Equity
Bond
Hybrid
Money market
* Characteristics of primary financial decision maker in the household.
investors come from all age groups, ownership is concentrated among individuals
in their prime saving and investing years. Two-thirds of households owning mutual
funds in 2012 were headed by individuals between the ages of 35 and 64. Interestingly, the number of families headed by a person with less than a college degree
investing in mutual funds is 52 percent. The bull markets of the 1990s, the low transaction costs of purchasing mutual funds shares, as well as the diversification benefits
achievable through mutual fund investments are again the likely reasons for these
trends. The typical fund-owning household had $120,000 invested in a median number of four mutual funds. Finally, 21 percent of investors who conducted equity fund
transactions used the Internet for some or all of these transactions. This compares to
6 percent in 1998. Notice, from Table 5–4, that compared to 1995, 2012 has seen an
increase in the median age of mutual fund holders (from 44 to 51 years) and a large
increase in median household financial assets owned (from $50,000 to $200,000) and
median mutual fund assets owned (from $18,000 to $120,000). Further, holdings of
equity funds have increased from 73 to 79 percent of all households.
Mutual Fund Objectives
Regulations require that mutual fund managers specify the investment objectives
of their funds in a prospectus available to potential investors. This prospectus
should include a list of the securities that the fund holds. The aggregate figures for
long-term equity, bond, and hybrid funds tend to obscure the fact that there are
many different funds in these groups. Every mutual fund sponsor offers multiple
120
Part One
Introduction
TABLE 5–5
Total Net Asset
Value of Equity,
Hybrid, and
Bond Funds
by Investment
Classification
Source: Investment
Company Institute, 2012
Investment Company Fact Book
(Washington, DC: Investment Company Institute,
2012). www.ici.org
Classification of Fund
Combined
Assets
($ billions)
Percent
of Total
Total net assets
$11,621.58
100.0%
Capital appreciation
World equity
Total return
Total equity funds
2,355.66
1,359.35
1,490.09
$ 5,205.10
20.3
11.7
12.8
44.8%
Total hybrid funds
$838.70
7.2%
Corporate bond
High-yield bond
World bond
Government bond
Strategic income
State municipal
National municipal
Total bond funds
452.60
212.12
259.51
261.09
1,204.14
158.91
337.99
$ 2,886.36
3.9
1.8
2.2
2.2
10.4
1.4
2.9
24.8%
Taxable money market funds
Tax-exempt money market funds
Total money market funds
2,399.72
291.70
$ 2,691.42
20.7
2.5
23.2%
funds of each type (e.g., long-term equity), differentiated by the securities held in
the particular mutual fund as defined by the fund’s objective. Table 5–5 classifies
13 major categories of investment objectives (or classifications) for mutual funds.
These objectives are shown along with the assets allocated to each major category. A fund objective provides general information about the types of securities
a mutual fund will hold as assets. For example, “capital appreciation” funds hold
securities (mainly equities) of high-growth, high-risk firms. Again, within each
of these 13 categories of mutual funds are a multitude of different funds offered
by mutual fund companies (see also the mutual fund quote section below). Historically, mutual funds have had to send out lengthy prospectuses describing their
objectives and investments. In 1998, the SEC adopted a new procedure in which
key sections of all funds’ prospectuses must be written in “plain” English instead
of legal boilerplate. The idea is to increase the ability of investors to understand
the risks related to the investment objectives or profile of a fund.
Internet Exercise
Go to the Vanguard Group’s website at www.vanguard.com. Find the latest prospectus
for the Vanguard 500 Index Admiral Fund using the following steps. Click on “Go to the
Personal Investors site.” In the box “Find a fund,” enter “Vanguard 500 Index Fund Admiral
Shares,” and click on “Go.” Click on “View prospectus and reports.” Click on “Statutory
Prospectus.” This downloads a file onto your computer that contains the prospectus. What is
listed as the primary investment objective for this fund?
It should be noted that, prior to 1998, the risk of returns [e.g., the fund’s total
return risk or even its “beta” (or systematic risk)] was rarely mentioned in prospectuses or advertisements. In 1998, the SEC adopted an initiative requiring mutual
funds to disclose more information about their return risk as well as the returns
Chapter 5
TABLE 5–6
Financial Services: Mutual Funds and Hedge Funds
121
Largest Mutual Funds by Assets Managed
Sources: The Wall Street Journal Online, January 18, 2013 and authors’ research. Reprinted by permission of The Wall Street Journal © 2013 Dow Jones &
Company, Inc. All Rights Reserved Worldwide. www.wsj.com
Name of Fund
Vanguard Tot Stk Inx;Inv
Vangaurd Instl Indx:Inst
Vanguard Tot Stk Idx; Adm
Vanguard 500 Index; Adm
Fidelity Contrafund
American Funds CIB;A
American Funds Inc;A
American Funds Growth;A
Vanguard Instl Index; InsP
American Funds CWGI;A
American Funds InvCoA
Franklin Cust;Inc;A
Dodge & Cox Intl Stock
Dodge & Cox Stock
American Funds Wash;A
Vanguard T StMk Idx; Inst
Vanguard Wellington;Adm
Vanguard Tot I Stk; Inv
American Funds Bal;A
American Funds FInv;A
www.americanfunds.com
www.vanguard.com
www.fidelity.com
Objective
Growth/Income
S&P 500 Index
Growth/Income
S&P 500 Index
Growth
Income
Income
Growth
S&P 500 Index
Global
Growth/Income
Income
International
Growth/Income
Growth/Income
Growth/Income
Balanced
International
Balanced
Growth/Income
Total Assets
(in millions)
$78,936
68,055
59,771
59,749
58,819
58,079
57,661
55,970
49,286
46,651
44,501
42,511
40,556
39,841
39,823
39,367
37,959
37,659
34,272
32,568
Total Return
12 month
17.40%
17.08
17.54
17.06
17.09
13.66
13.41
20.07
17.10
19.69
16.50
15.12
22.75
23.16
13.58
17.54
13.41
17.94
14.72
17.58
5 year
5.10%
4.46
5.22
4.45
4.95
2.54
4.86
3.54
4.48
1.45
3.14
5.66
0.75
2.55
4.02
5.22
5.93
⫺0.56
5.44
3.77
10 year
8.03%
7.25
8.13
7.23
10.06
7.91
7.94
8.33
7.28
10.26
6.81
8.81
11.65
7.54
6.77
8.15
8.51
9.59
7.17
9.33
NAV
$37.12
135.64
37.13
136.52
80.20
53.74
18.48
35.61
135.65
38.33
31.28
2.28
35.90
128.06
32.21
37.13
60.16
15.39
21.00
42.37
Initial
Fees
0.00%
0.00
0.00
0.00
0.00
5.75
5.75
5.75
0.00
5.75
5.75
4.25
0.00
0.00
5.75
0.00
0.00
0.00
5.75
5.75
themselves. The SEC’s rule was intended to better enable investors to compare
return-risk trade-offs from investing in different mutual funds.
Table 5–6 lists the largest (in total assets held) 20 mutual funds available in
January 2013, including the fund’s objective; total assets; 12-month, 5-year, and
10-year returns; net asset value (discussed below); and any initial fees (discussed
below). Vanguard’s Total Stock Market Index Fund, Investor Class Shares (which
seeks to track the performance of a benchmark index that measures the investment
return of the overall stock market), was the largest fund at the time. American
Funds, Vanguard, and Fidelity offered 17 of the top 20 funds measured by asset
size. Many of the top funds list either growth or growth and income as the fund
objective, and all of the top 20 funds performed well in 2012 as the stock market
saw high returns as the economy recovered from the financial crisis. Despite a relatively small downturn in the U.S. economy from 2001 through 2002 and a severe
financial crisis in 2008–09, all of the top 20 funds earned positive annual returns
over the period 2002–12. Over the three time periods (12 months, 5 years, and
10 years), the S&P 500 index saw annual returns of 13.59 percent, 2.32 percent, and
5.12 percent, respectively. Of the top mutual funds, 17 outperformed the S&P 500
index over the 12-month period, 17 outperformed it over the 5-year period, and all
20 funds outperformed the S&P 500 index over the 10-year period.
A growing number of the long-term mutual funds are index funds in which fund
managers buy securities in proportions similar to those included in a specified
122
Part One
Introduction
major stock index (such as the S&P 500 index). Thus, index funds are designed
to match the performance of a stock index. In 2012, 383 index funds managed
total net assets of $1.1 trillion. Because little research or aggressive management
is necessary for index funds, management fees (discussed later) are lower. However, returns are often higher than more actively managed funds. The difference
in returns between actively managed funds and passively managed index funds
can be explained. For example, from data analyzed by Morningstar and Forbes
over the period 2007–2010, it was found that 18 percent of actively managed funds
outperformed index fund portfolios. The overachieving, actively managed portfolios had a median outperformance of 0.4 percent annualized, while the 82 percent underperforming portfolios fell short by 1.0 percent annually.2 Further, the
average amount of expenses that an actively managed fund charges its shareholders every year is approximately 1.3 percent. Conversely, the Vanguard S&P 500
expense ratio is 0.19 percent. Finally, actively managed funds turn over their holdings rapidly. This turnover occurs at an average rate as high as 85 percent per year.
The transaction costs involved in buying and selling so many shares every year
result in an additional 0.7 percent of return disappearing every year.
Investor Returns from Mutual Fund Ownership
marked-to-market
Adjusting asset and
balance sheet values
to reflect current
market prices.
NAV
The net asset value
of a mutual fund;
equal to the market
value of the assets
in the mutual fund
portfolio divided by
the number of shares
outstanding.
EXAMPLE 5–1
Impact of Capital
Appreciation on
NAV
The return an investor gets from investing in mutual fund shares reflects three
aspects of the underlying portfolio of mutual fund assets. First, income and dividends are earned on those assets. Second, capital gains occur when assets are
sold by a mutual fund at prices higher than the purchase price. Third, capital
appreciation in the underlying values of the assets held in a fund’s portfolio add
to the value of mutual fund shares. With respect to capital appreciation, mutual
fund assets are normally marked-to-market daily. This means that the managers
of the fund calculate the current value of each mutual fund share by computing
the daily market value of the fund’s total asset portfolio and then dividing this
amount by the number of mutual fund shares outstanding. The resulting value
is called the net asset value (NAV) of the fund. This is the price the investor gets
when selling shares back to the fund that day or buying any new shares in the
fund on that day.
Suppose a mutual fund contains 2,000 shares of Sears, Roebuck currently trading at $45.50,
1,000 shares of Exxon/Mobil currently trading at $91.25, and 1,500 shares of AT&T currently
trading at $33.75. The mutual fund currently has 15,000 shares outstanding held by investors. Thus, today, the NAV of the fund is calculated as:
NAV ⫽ [(2,000 ⫻ $45.50) ⫹ (1,000 ⫻ $91.25) ⫹ (1,500 ⫻ $33.75)] ⫼ 15,000 ⫽ $15.525
If next month Sears shares increase to $50, Exxon/Mobil shares increase to $95, and AT&T
shares increase to $45, the NAV (assuming the same number of shares outstanding) would
increase to:
NAV ⫽ [(2,000 ⫻ $50) ⫹ (1,000 ⫻ $95) ⫹ (1,500 ⫻ $45)] ⫼ 15,000 ⫽ $17.50
2
The Power of Passive Investing: More Wealth with Less Work, Richard A. Ferri, 2011. John Wiley & Sons,
Inc. Hoboken, NJ.
Chapter 5
open-end mutual
fund
The supply of shares
in the fund is not
fixed but can increase
or decrease daily
with purchases and
redemptions of shares.
EXAMPLE 5–2
Impact of
Investment Size
on NAV
Financial Services: Mutual Funds and Hedge Funds
123
Most mutual funds are open-end in that the number of shares outstanding
fluctuates up and down daily with the amount of share redemptions and new
purchases. With open-end mutual funds, investors buy and sell shares from and
to the mutual fund company. Thus, the demand for shares determines the number
outstanding and the NAV of shares is determined solely by the market value of
the underlying securities held in the mutual fund divided by the number of shareholders outstanding.
Consider the mutual fund in Example 5–1, but suppose that today 1,000 additional investors
buy into the mutual fund at the current NAV of $15.525. This means that the fund manager
now has $15,525 in additional funds to invest. Suppose the fund manager decides to use
these additional funds to buy additional shares in AT&T. At today’s market price he or she
can buy $15,525 ⫼ $33.75 ⫽ 460 additional shares of AT&T. Thus, the mutual fund’s new
portfolio of shares would be 2,000 in Sears, 1,000 in Exxon/Mobil, and 1,960 in AT&T. At the
end of the month the NAV of the portfolio would be:
NAV ⫽ [(2,000 ⫻ $50) ⫹ (1,000 ⫻ $95) ⫹ (1,960 ⫻ $45)] ⫼ 16,000 ⫽ $17.70
given the appreciation in value of all three stocks over the month.
Note that the fund’s value changed over the month due to both capital appreciation and
investment size. A comparison of the NAV in Example 5–1 with the one in this example indicates that the additional shares alone enabled the fund to gain a slightly higher NAV than
had the number of shares remained static ($17.70 versus $17.50).
closed-end
investment
companies
Specialized investment companies that
invest in securities
and assets of other
firms but have a fixed
supply of shares outstanding themselves.
REIT
A real estate investment trust. A closedend investment
company that specializes in investing in
mortgages, property,
or real estate company shares.
Open-end mutual funds can be compared to most regular corporations traded
on stock exchanges and to closed-end investment companies, both of which
have a fixed number of shares outstanding at any given time. For example,
real estate investment trusts (REITs) are closed-end investment companies that
specialize in investment in real estate company shares and/or in buying mortgages.3 With closed-end funds, investors must buy and sell the investment company’s shares on a stock exchange similar to the trading of corporate stock. Since
the number of shares available for purchase at any moment in time is fixed, the
NAV of the fund’s shares is determined not only by the value of the underlying
shares but also by the demand for the investment company’s shares themselves.
When demand is high, the shares can trade at more than the NAV of the securities held in the fund. In this case, the fund is said to be trading at a premium, that
is, at more than the fair market value of the securities held. When the value of
the closed-end fund’s shares are less than the NAV of its assets, its shares are
said to be trading at a discount, that is, at less than the fair market value of the
securities held.
3
The total market value of funds invested in closed-end funds was $261.3 billion at the end of 2012.
This compares to $12,871.9 billion invested in open-end funds at that time.
124
Part One
Introduction
EXAMPLE 5–3
Market Value
of Closed-End
Mutual Fund
Shares
Because of high demand for a closed-end investment company’s shares, the 50 shares (NS)
are trading at $20 per share (PS). The market value of the equity-type securities in the fund’s
asset portfolio, however, is $800, or $16 ($800 ⫼ 50) per share. The market value balance
sheet of the fund is shown below:
Assets
Liabilities and Equity
Market value of asset portfolio
$800
Premium
$200
Market value of closed-end fund
shares (PS ⫻ NS)
$1,000
The fund’s shares are trading at a premium of $4 (200 ⫼ 50) per share.
Because of low demand for a second closed-end fund, the 100 shares outstanding are
trading at $25 per share. The market value of the securities in this fund’s portfolio is $3,000,
or each share has a NAV of $30 per share. The market value balance sheet of this fund is:
Assets
Liabilities and Equity
Market value of asset portfolio
$3,000
Discount
⫺$500
Market value of closed-end
fund shares (100 ⫻ $25)
$2,500
Exchange Traded Funds
Similar to closed-end funds in that a fixed number of shares are outstanding at
any point in time, an exchange-traded fund (ETF) is an investment company with
shares that trade intraday on stock exchanges at market-determined prices. ETFs
may be bought or sold through a broker or in a brokerage account, like trading
shares of any publicly traded company. While ETFs are registered with the SEC as
investment companies, they differ from traditional mutual funds both in how their
shares are issued and redeemed and in how their shares or units are traded. Specifically, ETF shares are created by an institutional investor’s depositing of a specified block of securities with the ETF. In return for this deposit, the institutional
investor receives a fixed amount of ETF shares, some or all of which may then
be sold on a stock exchange. The institutional investor may obtain its deposited
securities by redeeming the same number of ETF shares it received from the ETF.
Individual investors can buy and sell the ETF shares only when they are listed on
an exchange. Unlike an institutional investor, a retail investor cannot purchase or
redeem shares directly from the ETF, as with a traditional mutual fund.
Assets invested in the 1,193 ETFs in existence in 2012 totaled $1.29 trillion, up
from $66 billion invested in a total of 80 funds in 2000. Most ETFs are long-term
mutual funds that are designed to replicate a particular stock market index.4 ETFs
include funds such as SPDRs and Vanguard’s Large-Cap VIPERs funds.5 Like
4
However, in February 2008 the SEC gave approval for the first actively managed ETF.
SPDRs, Standard & Poor’s Depository Receipts, hold a portfolio of the equity securities that comprise the
Standard & Poor’s 500 Composite Stock Price Index. SPDRs seek investment results that, before expenses,
generally correspond to the price and yield performance of the Standard & Poor’s 500 Composite Stock
Price Index. Vanguard Large-Cap Index Participation Equity Receipts (VIPERs) seek to track the performance of a benchmark index that measures the investment return of large-capitalization stocks.
5
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
125
index funds, the share price of an ETF changes over time in response to a change
in the stock prices underlying a stock index. Further, like index funds, most ETFs
are intended to track a specific index, management of the funds is relatively
simple, and management fees are lower than those for actively managed mutual
funds. Unlike index funds, however, ETFs can be traded during the day, they can
be purchased on margin, and they can be sold short by an investor who expects a
drop in the underlying index value. Because ETFs behave like stocks, investors are
subject to capital gains taxes only when they sell their shares. Thus, ETF investors
can defer capital gains for as long as they hold the ETF.
www.morningstar.com
www.lipperweb.com
Mutual fund investors can get information on the performance of mutual funds
from several places. For example, for a comprehensive analysis of mutual funds,
Morningstar, Inc., offers information on more than 10,000 open-end and closedend funds. Morningstar does not own, operate, or hold an interest in any mutual
fund. Similarly, Lipper Analytical services, a subsidiary of Reuters, tracks the performance of more than 115,000 funds worldwide.
Mutual Fund Costs
Mutual funds charge shareholders a price or fee for the services they provide (i.e.,
management of a diversified portfolio of financial securities). Two types of fees
are incurred by investors: sales loads and fund operating expenses. We discuss
these next. The total cost to the shareholder of investing in a mutual fund is the
sum of the annualized sales load and other fees charged.
Load versus No-Load Funds
load fund
A mutual fund with
an up-front sales or
commission charge
that has to be paid by
the investor.
no-load fund
A mutual fund that
does not charge upfront fees or commission charges on the
sale of mutual fund
shares to investors.
An investor who buys a mutual fund share may be subject to a sales charge, sometimes as high as 5.75 percent. In this case, the fund is called a load fund.6 Other
funds that directly market shares to investors do not use sales agents working for
commissions and have no up-front commission charges. These are called no-load
funds.
The argument in favor of load funds is that their managers provide investors
with more personal attention and advice than managers of no-load funds. However, the cost of this increased attention may not be worthwhile. For example, the
last column in Table 5–6 lists initial fees for the largest U.S. stock funds in 2012.
Notice that only American Funds group and Franklin Templeton Custodian Funds
(Franklin Cust:Inc;A) assess a load fee on mutual fund share purchases. After
adjusting for this fee, the 12-month returns on the 10 American Funds mutual
funds fall from 20.07 percent to 13.41 percent (among the highest returns earned
by the largest funds) to 14.32 percent to 7.66 percent (among the lowest of the
returns on these funds). As Figure 5–3 indicates, investors increasingly recognized
this cost disadvantage for load funds in the 1990s as stock market values increased
broadly and dramatically. In 1985, load funds represented almost 70 percent of
equity mutual fund sales, and no-load funds represented just over 30 percent. By
1998 new sales of no-load mutual fund shares exceeded that of load fund shares,
and by 2002 total assets invested in no-load funds far exceeded those invested in
load funds. Of course, because the load fee is a one-time charge, it must be converted to an annualized charge incurred by the shareholder over the life of the
6
Another kind of load, called a back-end load, is sometimes charged when mutual fund shares are sold
by investors. Back-end loads, also referred to as deferred sales charges, are an alternative way to compensate the fund managers or sales force for their services.
126
Part One
Introduction
FIGURE 5–3 Load versus No-Load Fund Assets as a Share of Fund Assets (percent)
Source: Investment Company Institute, Investment Company Fact Book (Washington, DC: Investment Company Institute, various issues). www.ici.org
Equity funds (%)
100
90
80
70
Load
60
50
40
30
20
No-Load
10
0
Year
1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
investment. If the shareholder’s investment horizon is long term, the annualized
load fee can end up being quite small. If the investment horizon is short, however,
the load fee can leave the shareholder with little profit.
The demand for no-load funds by mutual fund investors has not gone unnoticed. Many companies, particularly discount brokers, now offer mutual fund
supermarkets through which investors can buy and sell mutual fund shares,
offered by several different mutual fund sponsors, through a single broker. The
most important feature of a fund supermarket is its non–transaction fee program,
whereby an investor may purchase mutual funds with no transaction fees from a
large number of fund companies. The broker is generally paid for services from
the fund’s 12b–1 fees (see below). The non–transaction fee offerings at a discount
broker often number in the thousands, providing an investor the convenience of
purchasing no-load funds from different families at a single location.
Fund Operating Expenses
12b–1 fees
Fees relating to the
distribution and other
operating costs of
mutual fund shares.
In contrast to one-time up-front load charges on the initial investment in a mutual
fund, annual fees are charged to cover all fund level expenses experienced as a
percent of the fund assets. One type of fee (called a management fee) is charged to
meet operating costs (such as administration and shareholder services). In addition, mutual funds generally require a small percentage (or fee) of investable
funds to meet fund level marketing and distribution costs. Such annual fees are
known as 12b–1 fees after the SEC rule covering such charges. These annual fees
cannot exceed 1 percent of a fund’s average net assets per year. Marketing and
servicing costs are capped at 0.25 percent per year, while management fees are
capped at 0.75 percent per year, for a total maximum 12b-1 charge of 1 percent per
year. Because these fees, charged to cover fund operating expenses, are paid out of
the fund’s assets, investors indirectly bear these expenses. These fees are generally
expressed as a percentage of the average net assets invested in the fund.
Chapter 5
EXAMPLE 5–4
Calculation of
Mutual Fund
Costs
Financial Services: Mutual Funds and Hedge Funds
127
The cost of mutual fund investing to a shareholder includes both the one-time sales load and
any annual fees charged. Because the sales load is a one-time charge, it must be converted
to an annualized payment incurred by the shareholder over the life of his or her investment.
With this conversion, the total shareholder cost of investing in a fund is the sum of the annualized sales load plus any annual fees.
For example, suppose an investor purchases fund shares with a 4 percent front-end load and
expects to hold the shares for 10 years. The annualized sales load7 incurred by the investor is:
4%/10 years ⫽ 0.4% per year
Further, suppose the fund has a total fund expense ratio (including 12b–1 fees) of 1 percent per year. The annual total shareholder cost for this fund is calculated as
0.4% ⫹ 1% ⫽ 1.4% per year
Funds sold through financial professionals such as brokers have recently
adopted alternative payment methods. These typically include an annual 12b–1
fee based on asset values that also may be combined with a front-end or back-end
sales charge. In many cases, funds offer several different share classes (all of which
invest in the same underlying portfolio of assets), but each share class may offer
investors different methods of paying for broker services. Indeed, in 2010, approximately two-thirds of all mutual funds had two or more share classes, compared to
1980 when all funds had only one share class. Most funds sold in multiple classes
offer investors three payment plans through three share classes (A, B, and C), each
having different mixes of sales loads and management and 12b–1 fees.
Class A shares represent the traditional means for paying for investment advice.
That is, class A shares carry a front-end load that is charged at the time of purchase
as a percent of the sales price. The front-end load on class A shares is charged on
new sales and is not generally incurred when class A shares are exchanged for
another mutual fund within the same fund family. In addition to the front-end
load, class A shares usually have annual management and 12b–1 fees that are used
to compensate brokers and sales professionals for ongoing assistance and service
provided to fund shareholders. The management and 12b–1 fees for class A shares
are typically between 25 and 35 basis points of the portfolio’s assets.
Unlike class A shares, class B shares are offered for sale at the NAV without a
front-end load. Class B share investors pay for advice and assistance from brokers
through a combination of annual management and 12b–1 fees (usually 1 percent)
and a back-end load. The back-end load is charged when shares are redeemed
(sold) and is typically based on the lesser of the original cost of the shares or the
market value at the time of sale. After six to eight years, class B shares typically
convert to class A shares, lowering the level of the annual management and 12b–1
fees from 1 percent to that of A shares.
Class C shares are offered at the NAV with no front-end load, and they typically recover distribution costs through a combination of annual management
and 12b–1 fees of 1 percent and a back-end load, set at 1 percent in the first
year of purchase. After the first year, no back-end load is charged on redemption. Class C shares usually do not convert to class A shares, and thus the annual
7
Convention in the industry is to annualize the sales load without adjusting for the time value of money.
128
Part One
Introduction
1 percent payment to the broker continues throughout the period of time that the
shares are held.
As discussed below, the lack of complete disclosure and the inability of most
mutual fund investors to understand the different fees charged for various classes
of mutual fund shares came under scrutiny in the early 2000s. Indeed, the potential for overcharging fees to various classes of mutual fund shareholders led to
the SEC creating new rules pertaining to these charges. Possibly as a result of
these scandals and new rules, more than 850 mutual funds decreased their management fees in 2005, and over 700 lowered their fees in 2006. The average fees
and expenses paid by mutual fund investors continue to fall. Investors paid
0.79 percent on the average stock fund in 2012, down from 1.98 percent in 1990
and 1.18 percent in 2004. Bond fund investors paid an average of 0.62 percent in
2009, down from 1.89 percent in 1990 and 0.92 percent in 2004.
Concept
Questions
1.
2.
3.
4.
Where do mutual funds rank in terms of asset size among all FI industries?
Describe the difference between short-term and long-term mutual funds.
What have been the trends in the number of mutual funds since 1980?
What are the three biggest mutual fund companies? How have their funds performed in recent years?
5. Describe the difference between open-end and closed-end mutual funds.
BALANCE SHEET AND RECENT TRENDS
FOR THE MUTUAL FUND INDUSTRY
Money Market Funds
The distribution of assets of money market mutual funds from 1990 through 2012
is shown in Table 5–7. As you can see, in 2012, $2,076.9 billion (82.8 percent of total
assets) was invested in short-term financial securities such as foreign deposits,
domestic checkable deposits and currency, time and savings deposits, repurchase
agreements (RPs), open market paper (mostly commercial paper), and U.S. government securities. This is up from 2007 (at the start of the financial crisis) when
$2,094.4 billion (or 69.0 percent) of financial assets were invested in short-term
securities. As financial markets tumbled in 2008, money market mutual funds
moved investments out of corporate and foreign bonds (12.4 percent of the total in
2007 and 6.1 percent in 2008) into safer securities such as U.S. government securities (13.6 percent of the total investments in 2007 and 35.5 percent in 2008). Shortmaturity asset holdings reflect the objective of these funds to retain the depositlike
nature of the share liabilities they issue. In fact, most money market mutual fund
shares have their values fixed at $1. Asset value fluctuations due to interest rate
changes and capital gains or losses on assets are adjusted for by increasing or
reducing the number of $1 shares owned by the investor.
In addition to these typical risks faced by fund mangers, money market mutual
funds experienced unusual liquidity risk at the start of the financial crisis. On
September 16, 2008 (one day after Lehman Brothers filed for bankruptcy), Reserve
Primary Fund, the oldest money market fund in the United States, saw its shares
fall to an equivalent of 97 cents (below the $1.00 book value) after writing off debt
Chapter 5
TABLE 5–7
Financial Services: Mutual Funds and Hedge Funds
129
Distribution of Assets in Money Market Mutual Funds, 1990–2012 (in billions of dollars)
Source: Federal Reserve Board, “Flow of Fund Accounts,” various issues. www.federalreserve.gov
1990
1995
2000
2005
2007
2008
2010
2012
Total financial assets
$493.3 $745.3 $1,812.1 $2,006.9 $3,033.1 $3,757.3 $2,755.3 $2,506.9
Foreign deposits
26.7
19.7
91.1
94.7
127.3
129.3
105.9
40.2
Checkable deposits
and currency
11.2 ⫺3.5
2.2
⫺0.9
1.9
7.5
14.2
11.3
Time and savings
deposits
21.9
52.3
142.4
183.0
270.7
355.2
468.0
405.3
Security RPs
58.2
87.8
183.0
346.0
605.9
542.4
479.3
513.1
Credit market
instruments
371.3 545.5 1,290.9 1,340.8 1,936.4 2,675.0 1,621.0 1,471.6
Open market paper 204.0 235.5
608.6
492.2
674.6
618.5
394.2
319.4
Treasury
44.9
70.0
90.4
88.6
178.1
577.7
335.4
456.3
Agency
36.4
90.8
185.2
160.1
235.9
756.2
402.8
331.3
Municipal securities
84.0 127.7
244.7
336.7
471.0
494.6
334.4
271.6
Corporate and
foreign bonds
2.0
21.5
161.9
263.2
376.8
228.0
154.2
93.0
Miscellaneous assets
4.0
43.4
102.5
43.3
90.9
47.9
66.9
65.4
Percent of
Total, 2012
100.0%
1.6
0.5
16.2
20.5
58.6
12.7
18.2
13.2
10.8
3.7
2.6
issued by Lehman Brothers. Resulting investor anxiety about Reserve Primary
Fund spread to other funds, and investors industrywide liquidated their MMMF
shares. In just one week investors liquidated over $200 billion of the industry total
$4 trillion invested in MMMFs. In response, on September 19 the federal government took steps to restore confidence in the MMMF industry. Specifically, the
Department of Treasury opened the Temporary Guarantee Program for MMMFs,
which provided up to $50 billion in coverage to MMMF shareholders for amounts
they held in the funds as of close of business that day. The guarantee was triggered if a participating fund’s net asset value fell below $0.995. The program was
designed to address the severe liquidity strains in the industry and immediately
stabilized the industry and stopped the outflows.
EXAMPLE 5–5
Calculation
of Number
of Shares
Outstanding in
a Money Market
Mutual Fund
Due to a drop in interest rates, the market value of the assets held by a particular MMMF
increases from $100 to $110. The market value balance sheet for the mutual fund before and
after the drop in interest rates is:
Assets
Liabilities and Equity
(a) Before the interest rate drop:
Market value of MMMF assets
$100
Market value of MMMF fund
shares (100 shares ⫻ $1)
$100
(b) After the interest rate drop:
Market value of MMMF assets
110
Market value of MMMF fund
shares (110 shares ⫻ $1)
110
The interest rate drop results in 10 (110 ⫺ 100) new equity-type shares that are held by investors in the MMMF, reflecting the increase in the market value of the MMMF’s assets of $10
(i.e., 10 new shares of $1 each).
130
Part One
TABLE 5–8
Introduction
Distribution of Assets in Bond, Equity, and Hybrid Mutual Funds, 1990–2012 (in billions of
dollars)
Source: Federal Reserve Board, “Flow of Fund Accounts,” various issues. www.federalreserve.gov
1990
1995
2000
2005
2007
2008
2010
2012
Percent
of Total,
2012
Total financial assets
$608.4 $1,852.8 $4,434.6 $6,048.9 $7,829.0 $5,435.3 $7,934.5 $9,262.4 100.0%
Security RPs
6.1
50.2
106.4
115.4
132.2
124.7
137.5
222.7
2.4
Credit market
instruments
360.1
771.3 1,097.8 1,747.1 2,203.1 2,276.5 3,031.4 4,035.5
43.6
Open market paper
28.5
50.2
106.4
97.1
114.1
51.6
66.3
131.1
1.4
Treasury
111.1
205.3
123.7
155.7
179.2
187.9
297.4
427.6
4.6
Agency
48.6
109.9
275.3
483.4
565.2
592.7
791.1 1,066.6
11.5
Municipal securities 112.6
210.2
230.5
311.7
372.2
389.6
526.6
612.8
6.6
Corporate and
foreign bonds
59.3
185.5
337.6
662.7
889.9
959.9 1,275.4 1,701.9
18.4
Other loans and
advances
0.0
10.2
24.3
36.5
82.5
94.8
74.6
95.5
1.1
Corporate equities
233.2 1,024.9 3,226.9 4,175.7 5,476.9 3,014.1 4,762.7 5,004.2
54.0
Miscellaneous assets
8.9
6.3
3.5
10.7
16.8
20.0
2.9
0.0
0.0
Long-Term Funds
Note the asset composition of long-term mutual funds shown in Table 5–8. As
might be expected, it reflects the popularity of different types of bond or equity
funds at any point in time. For example, underscoring the attractiveness of equity
funds in 2007 was the fact that stocks comprised over 70.0 percent of total longterm mutual fund asset portfolios. Credit market instruments were the next most
popular assets (28.1 percent of the asset portfolio). In contrast, look at the distribution of assets in 2008, when the equity markets were plummeting. Equities
made up only 55.5 percent of the long-term mutual fund portfolios and credit
market instruments were 41.9 percent of total assets. Note too that total financial
assets fell from $7,829.0 billion in 2007 (before the start of the financial crisis) to
just $5,435.3 billion in 2008 (at the height of the crisis), a drop of 30.6 percent. As
the economy and financial markets recovered (in 2010), financial assets held by
long-term mutual funds increased to $7,934.5 billion, of which only 60.0 percent
were corporate equities. In 2012, long-term funds held financial assets totaling
$9,262.4 billion, of which 54.0 percent were corporate equities. Thus, even four
years after the start of the financial crisis, long-term funds had not switched their
holdings of corporate equities back to pre-crisis levels.
Concept
Questions
1. Describe the major assets held by mutual funds in the 1990s and 2000s.
2. How does the asset distribution differ between money market mutual funds and
long-term mutual funds?
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
131
REGULATION OF MUTUAL FUNDS
www.sec.gov
www.nasd.com
Because mutual funds manage and invest small investors’ savings, this industry is
heavily regulated. Indeed, many regulations have been enacted to protect investors against possible abuses by managers of mutual funds. The SEC is the primary regulator of mutual funds. Specifically, the Securities Act of 1933 requires a
mutual fund to file a registration statement with the SEC and sets rules and procedures regarding the fund’s prospectus sent to investors. In addition, the Securities
Exchange Act of 1934 makes the purchase and sale of mutual fund shares subject
to various antifraud provisions. This regulation requires that a mutual fund furnish full and accurate information on all financial and corporate matters to prospective fund purchasers. The 1934 act also appointed the National Association of
Securities Dealers (NASD) to supervise mutual fund share distributions. In 1940
Congress passed the Investment Advisers Act and the Investment Company Act.
The Investment Advisers Act regulates the activities of mutual fund advisors. The
Investment Company Act sets out rules to prevent conflicts of interest, fraud, and
excessive fees or charges for fund shares.
More recently, the passage of the Insider Trading and Securities Fraud Enforcement Act of 1988 has required mutual funds to develop mechanisms and procedures to avoid insider trading abuses. In addition, the Market Reform Act of 1990,
passed in the wake of the 1987 stock market crash, allows the SEC to introduce
circuit breakers to halt trading on exchanges and to restrict program trading when
it deems necessary. Finally, the National Securities Markets Improvement Act
(NSMIA) of 1996 also applies to mutual fund companies. Specifically, the NSMIA
exempts mutual fund sellers from oversight by state securities regulators, thus
reducing their regulatory burden.
Despite the many regulations imposed on mutual fund companies, several
allegations of trading abuses and improper assignment of fees were revealed and
prosecuted in the early 2000s. The abusive activities fell into four general categories: market timing, late trading, directed brokerage, and improper assessment of
fees to investors.
Market timing involves short-term trading of mutual funds that seeks to take
advantage of short-term discrepancies between the price of a mutual fund’s
shares and out-of-date values on the securities in the fund’s portfolio. It is especially common in international funds as traders can exploit differences in time
zones. Typically, market timers hold a fund for only a few days. For example,
when Asian markets close with losses, but are expected to rebound the following
day, market timers can buy a U.S. mutual fund, investing in Asian securities after
the loss on that day and then sell the shares for a profit the next day. This singleday investment dilutes the profits of the fund’s long-term investors, while market
timers profit without much risk.
Late trading allegations involved cases in which some investors were able to
buy or sell mutual fund shares long after the price had been set at 4 pm eastern
time each day (i.e., after the close of the NYSE and NASDAQ). Under existing
rules, investors had to place an order with their broker or another FI by 4 pm.
But the mutual fund company may not have received the order until much later,
sometimes as late as 9 pm. However, because of this time delay, some large investors had been able to call their broker back after the market closed and alter or
cancel their order.
132
Part One
Introduction
Directed brokerage involves arrangements between mutual fund companies
and brokerage houses and whether those agreements improperly influenced
which funds brokers recommended to investors. The investigation examined
whether some mutual fund companies agreed to direct orders for stock and
bond purchases and sales to brokerage houses that agreed to promote sales of the
mutual fund company’s products.
Finally, regulators claimed that the disclosure of 12b–1 fees allowed some brokers to trick investors into believing they were buying no-load funds. Before 12b–1
fees, all funds sold through brokers carried front-end load fees. As discussed
above, with 12b–1 fees, fund companies introduced share classes, some of which
carried back-end loads that declined over time and others that charged annual
fees of up to 1 percent of asset values. Funds classes that charged annual 12b–1
fees would see performance decrease by that amount and thus not perform as
well as an identical fund that carried a lower 12b–1 fee. The shareholder, however,
saw only the fund’s raw return (before annual fees) and not the dollar amount of
the fee paid. Further, regulators discovered in late 2002 that brokers often overcharged customers by failing to provide discounts to fund investors who qualified
to receive them. Since discount policies differ from fund to fund, brokers did not
always realize which customers qualified for them.
The result of these illegal and abusive activities was new rules and regulations
imposed (in 2004 and 2005) on mutual fund companies. The rules were intended
to give investors more information about conflicts of interest, improve fund governance, and close legal loopholes that some fund managers had abused. Many
of these new rules involve changes to the way mutual funds operate, including
requirements that funds have an independent board headed by an independent
chairman. Specifically, the SEC required an increase in the percentage of independent board members to 75 percent from the previous level of 50 percent and
required mutual fund companies to have independent board chairs (a move that
would displace the sitting chairmen at about 80 percent of the nations mutual
funds). The SEC saw independent directors as those who better serve as watchdogs guarding investors’ interests. Further, the Sarbanes-Oxley Act of 2002
requires public companies, including mutual fund companies, to make sure their
boards’ audit committees have at least one individual who is familiar with generally accepted accounting principles and has experience with internal auditing
controls, preparing or auditing financial statements of “generally comparable
issuers,” and applying GAAP principles for estimates, accruals, and reserves.
The SEC also took steps to close a loophole that allowed improper trading to
go unnoticed at some mutual funds. Prior to the new rules, the SEC required that
funds report trading by senior employees in individual stocks but not in shares of
mutual funds they manage. The SEC now requires portfolio managers to report
trading in funds they manage. Investment advisors also have to protect information about stock selections and client holding and transactions. The SEC and other
regulators had found that advisory personnel revealed confidential information
about fund portfolio holdings so that others could exploit the funds.
To address the problem of market timing, the SEC now requires funds to provide expanded disclosure of the risks of frequent trading in fund shares and of
their policies and procedures regarding such activities. Mutual funds also now
have to be more open about their use of fair value pricing (a practice of estimating
the value of rarely traded securities or updating the values of non-U.S. securities
that last traded many hours before U.S. funds calculate their share prices each day)
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
133
to guard against stale share prices that could produce profits for market timers.
The market timing provisions also require mutual funds to explain when they use
fair value pricing. Fair value pricing is one of the most effective ways of combating the market timing that was most common in some mutual funds holding nonU.S. stocks. Many mutual funds had rarely used fair value pricing. Further, new
SEC rules require brokers to tell investors about any payments, compensation, or
other incentives they receive from fund companies including whether they are
paid more to sell a certain fund. Conflicts would have to be disclosed before the
sale is completed.
To ensure that the required rule changes take place, starting October 5, 2004, the
SEC required that mutual funds hire chief compliance officers to monitor whether
the mutual fund company follows the rules. The chief compliance officer reports
directly to mutual fund directors, and not to executives of the fund management
company. To further insulate the chief compliance officer from being bullied into
keeping quiet about improper behavior, only the fund board can fire the compliance officer. Duties of the compliance officer include policing personal trading
by fund managers, ensuring accuracy of information provided to regulators and
investors, reviewing fund business practices such as allocating trading commissions, and reporting any wrongdoing directly to fund directors.
Finally, the new SEC rules call for shareholder reports to include the fees shareholders pay during any period covered, as well as management’s discussion of
the fund’s performance over that period. As of September 1, 2004, mutual fund
companies must provide clear information to investors on brokerage commissions and discounts, including improved disclosure on up-front sales charges for
broker-sold mutual funds. Investors now get a document showing the amount
they paid for a fund, the amount their broker was paid, and how the fund compares with industry averages based on fees, sales loads, and brokerage commissions. As of December 2004, mutual funds must provide to investors summary
information in a fund prospectus on eligibility for breakpoint discounts and
explain what records investors may need to show brokers to demonstrate they
qualify for discounts.
The SEC also proposed that mutual funds or their agents receive all trading
orders by 4 pm eastern time, when the fund’s daily price is calculated. This “hard
closing,” which would require fund orders to be in the hands of the mutual fund
companies by 4 pm, is intended to halt late trading abuses.
In March 2009, the SEC adopted amendments to the form used by mutual funds
to register under the Investment Company Act of 1940 and to offer their securities
under the Securities Act of 1933 in order to enhance the disclosures that are provided to mutual fund investors. The amendments (first proposed in November
2007) require key information to appear in plain English in a standardized order at
the front of the mutual fund statutory prospectus. The amendment also includes a
new option for satisfying prospectus delivery obligations with respect to mutual
fund securities under the Securities Act. Under the option, key information is sent
or given to investors in the form of a summary prospectus and the statutory prospectus is provided on an Internet website. The improved disclosure framework
was intended to provide investors with information that is easier to use and more
readily accessible, while retaining the comprehensive quality of the information
that was previously available.
Finally, in a February 2013 letter sent to the Financial Stability Oversight
Council (FSOC) (set up as a result of the Wall Street Reform and Consumer
134
Part One
Introduction
Protection Act to oversee the financial system), the leaders of all 12 regional Federal Reserve banks called for a significant overhaul of the money market industry. The letter stated that even four years after the financial crisis, without reform
money, market mutual fund activities could spread the risk of significant credit
problems from the funds to banks to the broader financial system. New York Fed
president William Dudley stated that the risk of a run on money market funds was
potentially higher in 2013 than before the crisis because banks increasingly used
these funds as a source of financing and because Congress blocked the Fed and
Treasury from using certain emergency tools that could stabilize the funds during
a market panic. A proposal released in November 2012 by the FSOC included a
requirement for money market mutual funds to let fund prices adjust to changes
in the net asset value of the funds’ holdings, rather than fixing values at $1 a share.
The logic behind the proposal is that with a floating value, investors would be
less likely to rush to pull their cash out of the funds before share values “break
the buck,” as happened during the 2008 crisis (discussed earlier). However, little
action followed the release of the proposal. The joint letter by the Fed presidents
was intended to serve as impetus to renew the push for reform.
Concept
Questions
1. Who is the primary regulator of mutual fund companies?
2. How did the NSMIA affect mutual funds?
GLOBAL ISSUES IN THE MUTUAL FUND INDUSTRY
£ ¥
:$
As discussed throughout the chapter, mutual funds have been the fastest-growing
sector in the U.S. financial institutions industry throughout the 1990s and into
the 2000s. Only the worldwide financial crisis and the worst worldwide recession since the Great Depression curtailed the growth in this industry. Worldwide
investment in mutual funds is shown in Table 5–9. Combined assets invested in
non-U.S. mutual funds are approximately equal to that invested in U.S. mutual
funds alone. However, recent growth in non-U.S. funds has exceeded that in U.S.
funds. Worldwide (other than in the United States), investments in mutual funds
have increased more than 211 percent, from $4.545 trillion in 1999 to $14.130 trillion
in 2007. This compares with growth of 75 percent in U.S. funds. Likewise, non-U.S.
mutual funds experienced bigger losses in total assets during the financial crisis.
Worldwide funds fell to $9.316 trillion (34.1 percent) in 2008, while U.S. funds
fell to $9.601 trillion (20.1 percent). By 2012, as worldwide economies improved,
worldwide investments in mutual funds increased to $13.291 trillion (an increase
of 42.7 percent from 2008), while U.S. investments increased to $12.754 trillion
(an increase of 32.8 percent). In addition, as this industry developed in countries
throughout the world, the number of mutual funds worldwide (other than in the
United States) increased 46.4 percent, from 44,955 in 1999 to 65,795 in 2012. Much
more established in the United States, the number of U.S. mutual funds decreased
by almost 3 percent over this period. In 2012, of the total amount invested in
mutual funds outside the United States, 35 percent was in equity funds, 16 percent
in bond funds, 19 percent in hybrid funds, 22 percent in money market funds, and
8 percent in other funds.
TABLE 5–9
Worldwide Assets of Open-End Investment Companies* (in millions of dollars)
Source: Investment Company Institute, Investment Company Fact Book (Washington, DC: Investment Company Institute, various issues). www.ici.org
Non-U.S. Countries
1999
6,990
N/A
56,254
65,461
117,758
N/A
269,825
4,091
N/A
N/A
1,473
27,558
10,318
656,132
237,312
36,397
182,265
1,725
13,065
95,174
475,661
502,752
167,177
N/A
661,084
N/A
19,468
94,539
8,502
15,107
N/A
117
762
19,704
N/A
177
N/A
N/A
18,235
207,603
83,250
82,512
31,153
N/A
N/A
375,199
2002
$
1,021
356,304
66,877
74,983
96,729
N/A
248,979
6,705
N/A
1,738
3,297
40,153
16,516
845,147
209,168
26,621
164,322
3,992
20,364
250,116
378,259
303,191
149,544
3,847
803,869
N/A
30,759
84,211
7,505
15,471
N/A
474
5,468
19,969
27
372
N/A
N/A
20,983
179,133
57,992
82,622
62,153
N/A
6,002
288,887
2007
$
6,789
1,192,992
138,709
149,842
615,365
N/A
698,397
24,444
434,063
1,203
7,595
104,082
81,136
1,989,690
372,072
29,807
818,421
12,577
108,582
951,371
419,687
713,998
329,979
25,103
2,685,065
N/A
75,428
113,759
14,924
74,709
4,956
2,090
45,542
29,732
390
7,175
4,762
4,219
95,221
396,354
194,955
176,282
58,323
N/A
22,609
897,460
2008
$
3,867
841,133
93,269
105,057
479,321
226
416,031
17,587
276,303
1,098
5,260
65,182
48,750
1,591,082
237,986
12,189
N/A
9,188
62,805
720,486
263,588
575,327
221,992
20,489
1,860,763
N/A
60,435
77,379
10,612
41,157
1,985
1,263
17,782
13,572
326
2,026
3,841
2,067
69,417
270,983
113,331
135,052
46,116
N/A
15,404
504,681
2012†
2010
Argentina
Australia
Austria
Belgium
Brazil
Bulgaria
Canada
Chile
China
Costa Rica
Czech Republic
Denmark‡
Finland
France
Germany
Greece
Hong Kong
Hungary
India
Ireland
Italy
Japan
Korea
Liechtenstein
Luxembourg
Malta
Mexico
Netherlands
New Zealand
Norway
Pakistan
Philippines
Poland
Portugal
Romania
Russia
Slovakia
Slovenia
South Africa
Spain
Sweden
Switzerland
Taiwan
Trinidad & Tobago
Turkey
United Kingdom
$
$
Total non-U.S.
$ 4,544,799
$ 4,933,771
$14,130,041
$ 9,316,409
$12,878,305
$13,290,983
Total U.S.
Total world
$ 6,846,339
$11,391,138
$ 6,390,360
$11,324,131
$12,020,895
$26,150,936
$ 9,601,090
$18,917,499
$11,820,865
$24,699,170
$12,754,273
$26,045,256
* Funds of funds are not included. Data include home-domiciled funds, except for Hong Kong, Korea, and New Zealand.
†
As of end of the third quarter.
‡
Before 2003, data include special funds reserved for institutional investors.
Note: Components may not add to total because of rounding.
5,179
1,455,850
94,670
96,288
5,179
302
636,947
38,243
364,985
1,470
5,508
89,800
71,210
1,617,176
333,713
8,627
N/A
11,532
111,421
1,014,104
234,313
785,504
266,495
35,387
2,512,874
N/A
98,094
85,924
19,562
84,505
2,290
2,184
25,595
11,004
1,713
3,917
4,349
2,663
141,615
216,915
205,449
261,893
59,032
5,812
19,545
854,413
$
8,571
1,610,190
85,288
82,499
8,571
296
840,890
35,040
373,519
1,651
4,657
98,525
70,483
1,439,987
314,040
5,001
N/A
8,082
110,021
1,216,670
176,227
753,552
255,419
32,459
2,510,001
3,002
109,481
70,634
30,020
93,890
3,214
3,210
22,554
6,987
2,400
N/A
2,882
2,340
138,283
188,660
199,454
310,504
57,282
6,388
15,862
938,832
135
136
Part One
Introduction
As may be expected, the worldwide mutual fund market is most active in
those countries with the most sophisticated securities markets (e.g., Japan, France,
Australia, and the United Kingdom). However, in the late 1990s and early 2000s,
the faltering Japanese economy resulted in a decrease in both the assets invested
in and the number of mutual funds. Assets invested in Japanese mutual funds fell
from $502.7 billion in 1999 to $303.2 billion in 2002 (a drop of 39.7 percent) and
the number of funds fell from 3,444 to 2,718 (21.1 percent) over the period. Some
U.S. FIs saw this decline in the Japanese market as an opportunity. U.S. FIs such
as Paine Webber Group (teaming up with Yasuda Life Insurance Co.) and Merrill
Lynch (buying the assets of failed Japanese brokerage firm Yamaichi Securities)
entered the Japanese mutual fund market in the late 1990s and early 2000s. The
U.S. FIs saw Japan as a profitable market for mutual fund sales, noting that about
60 percent of Japan’s savings was in low-yielding bank deposits or governmentrun institutions.
Although U.S. mutual fund companies sponsor funds abroad, barriers to entry
overseas are typically higher than in the United States. The U.S. mutual fund
industry has worked to lower the barriers that prevent U.S. mutual fund firms
from marketing their services more widely and to improve competition in the
often diverse fund markets around the world. The U.S. mutual fund industry,
for example, has worked to achieve a true cross-border market for mutual fund
companies in Europe and to ensure that publicly offered mutual fund companies can be used as funding vehicles in the retirement fund market in Europe and
Japan. The industry also has sought to reduce barriers for U.S. mutual fund sponsors seeking to offer mutual fund company products in China and other Asian
countries.
Concept
Question
1. What have been the trends in the assets invested in worldwide mutual funds from
the 1990s through the 2000s?
HEDGE FUNDS
Hedge funds are a type of investment pool that solicits funds from (wealthy)
individuals and other investors (e.g., commercial banks) and invests these funds
on their behalf. Hedge funds are similar to mutual funds in that they are pooled
investment vehicles that accept investors’ money and generally invest it on a collective basis. Hedge funds are, however, not subject to the numerous regulations
that apply to mutual funds for the protection of individuals, such as regulations
requiring a certain degree of liquidity, regulations requiring that mutual fund
shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to ensure fairness in the pricing of funds shares, disclosure regulations, and regulations limiting the use of leverage. Further, hedge funds do not
have to disclose their full activities to third parties. Thus, they offer a high degree
of privacy for their investors. Until 2010, hedge funds were not required to register
with the SEC. Thus, they were subject to virtually no regulatory oversight (e.g., by
the SEC under the Securities Act and Investment Advisers Act) and generally took
significant risk. Even after 2010, hedge funds offered in the United States avoid
regulations by limiting the asset size of the fund (see below).
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
137
Historically, hedge funds avoided regulations by limiting the number of investors to less than 100 individuals (below that required for SEC registration), who
must be deemed “accredited investors.” To be accredited, an investor must have
a net worth of more than $1 million or have an annual income of at least $200,000
($300,000 if married). These stiff financial requirements allowed hedge funds to
avoid regulation under the theory that individuals with such wealth should be
able to evaluate the risk and return on their investments. According to the SEC,
these types of investors should be expected to make more informed decisions and
take on higher levels of risk. However, as a result of some heavily publicized hedge
fund failures and near failures (the result of fraud by fund managers, e.g., Bernard
L. Madoff Investment Securities, and the financial crisis, e.g., Bear Stearns High
Grade Structured Credit Strategies Fund), in 2010 federal regulators increased the
oversight of hedge funds (see below).
Even with this increased oversight, because hedge funds remain exempt from
many of the rules and regulations governing mutual funds, they can use aggressive strategies that are unavailable to mutual funds, including short selling, leveraging, program trading, arbitrage, and derivatives trading. Further, since hedge
funds that do not exceed $100 million in assets under management do not register
with the SEC, their actual data cannot be independently tracked. Therefore, much
hedge fund data are self-reported. It is estimated that in 2013 there were more
than 8,000 hedge funds in the world, with managed assets estimated at $2.25 trillion. Table 5–10 lists the 10 largest hedge funds by total assets managed in 2013.
Hedge funds grew in popularity in the 1990s as investors saw returns of more
than 40 percent after management fees (often more than 25 percent of the fund’s
profits). They came to the forefront of the news in the late 1990s when one large
hedge fund, Long-Term Capital Management (LTCM), nearly collapsed. The near
collapse of LTCM not only hurt its investors, but arguably came close to damaging the world’s financial system. So great was the potential impact of the failure
of LTCM that the Federal Reserve felt it was necessary to intervene by brokering a
$3.6 billion bailout of LTCM by a consortium of some of the world’s largest financial institutions.
Some hedge funds take positions (using sophisticated computer models) speculating that some prices will rise faster than others. For example, a hedge fund
may buy (take a long position in) a bond expecting that its price will rise. At the
TABLE 5–10
Largest Hedge
Fund Firms by
Assets Managed
Source: Institutional
Investor, January 2013.
www.institutionalinvestor.com
Name of Fund
Country
Bridgewater Associates
J.P. Morgan Asset Management
Man Group
Brevan Howard Asset Management
Winton Capital Management
Och-Ziff Capital Management Group
BlackRock
BlueCrest Capital Management
Baupost Group
AQR Capital Management
United States
United States
United Kingdom
United Kingdom
United Kingdom
United States
United States
United Kingdom
United States
United States
Total Assets
(in billions)
$76.1
53.6
38.5
34.2
30.0
28.8
28.8
28.6
25.2
23.2
138
Part One
Introduction
same time the fund will borrow (taking a short position) in another bond and sell
it, promising to return the borrowed bond in the future. Generally, bond prices
tend to move up and down together. Thus, if prices go up as expected, the hedge
fund will gain on the bond it purchased while losing money on the bond it borrowed. The hedge fund will make a profit if the gain on the bond it purchased is
larger than the loss on the bond it borrowed. If, contrary to expectations, bond
prices fall, the hedge fund will make a profit if the gains on the bond it borrowed
are greater than the losses on the bond it bought. Thus, regardless of the change in
prices, the simultaneous long and short positions in bonds will minimize the risk
of overall losses for the hedge fund.
Types of Hedge Funds
Most hedge funds are highly specialized, relying on the specific expertise of the fund
manager(s) to produce a profit. Hedge fund managers follow a variety of investment strategies, some of which use leverage and derivatives, while others use more
conservative strategies and involve little or no leverage. Generally, hedge funds are
set up with specific parameters so that investors can forecast a risk-return profile.
Figure 5–4 shows the general categories of hedge funds by risk classification.
More risky funds are the most aggressive and may produce profits in many types
of market environments. Funds in this group are classified by objectives such as
aggressive growth, emerging markets, macro, market timing, and short selling.
Aggressive growth funds invest in equities expected to experience acceleration
in growth of earnings per share. Generally, high price-to-earnings ratio, low or no
dividend companies are included. These funds hedge by shorting equities where
earnings disappointment is expected or by shorting stock indexes. Emerging market funds invest in equity or debt securities of emerging markets, which tend to
have higher inflation and volatile growth. Macro funds aim to profit from changes
in global economies, typically brought about by shifts in government policy that
impact interest rates. These funds include investments in equities, bonds, currencies, and commodities. They use leverage and derivatives to accentuate the impact
of market moves. Market timing funds allocate assets among different asset classes
depending on the manager’s view of the economic or market outlook. Thus, portfolio emphasis may swing widely between asset classes. The unpredictability of
FIGURE 5–4 Classification of Hedge Funds
More Risky
Market directional—These funds seek high returns using leverage, typically
investing based on anticipated events.
Moderate Risk
Market neutral or value orientation—These funds have moderate exposure to
market risk, typically favoring a longer-term investment strategy.
Risk Avoidance
Market neutral—These funds strive for moderate, consistent returns with low
risk.
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
139
market movements and the difficulty of timing entry and exit from markets add
significant risk to this strategy. Short-selling funds sell securities in anticipation of
being able to buy them back in the future at a lower price based on the manager’s
assessment of the overvaluation of the securities or in anticipation of earnings
disappointments.
Moderate risk funds are more traditional funds, similar to mutual funds, with
only a portion of the portfolio being hedged. Funds in this group are classified by
objectives such as distressed securities, fund of funds, opportunistic, multistrategy, and special situations. Distressed securities funds buy equity, debt, or trade
claims, at deep discounts, of companies in or facing bankruptcy or reorganization.
Profit opportunities come from the market’s lack of understanding of the true
value of these deep-discount securities and from the fact that the majority of institutional investors cannot own below-investment-grade securities. Funds of funds
mix hedge funds and other pooled investment vehicles. This blending of different
strategies and asset classes aims to provide a more stable long-term investment
return than any of the individual funds. Returns and risk can be controlled by
the mix of underlying strategies and funds. Capital preservation is generally an
important consideration for these funds. Opportunistic funds change their investment strategy as opportunities arise to profit from events such as IPOs, sudden
price changes resulting from a disappointing earnings announcement, and hostile
takeover bids. These funds may utilize several investing styles at any point in
time and are not restricted to any particular investment approach or asset class.
Multistrategy funds take a diversified investment approach by implementing
various strategies simultaneously to realize short- and long-term gains. This style
of investment allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Special-situation funds
invest in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. These funds may undertake the simultaneous purchase of stock in a company being acquired and sale of stock in its bidder, hoping
to profit from the spread between the current market price and the final purchase
price of the company.
Risk-avoidance funds are also more traditional funds, emphasizing consistent
but moderate returns while avoiding risk. Funds in this group are classified by
objectives such as income, market neutral–arbitrage, market neutral–securities
hedging, and value. Income funds invest with the primary focus on yield or current income rather than solely on capital gains. These funds use leverage to buy
bonds and some fixed-income derivatives, profiting from principal appreciation
and interest income. Market neutral–arbitrage funds attempt to hedge market
risk by taking offsetting positions, often in different securities of the same issuer,
for example, long convertible bonds and short the firm’s equity. Their focus is on
obtaining returns with low or no correlation to both equity and bond markets.
Market neutral–securities hedging funds invest equally in long and short equity
portfolios in particular market sectors. Market risk is reduced, but effective stock
analysis is critical to obtaining a profit. These funds use leverage to magnify their
returns. They also sometimes use market index futures to hedge systematic risk.
Value funds invest in securities perceived to be selling at deep discounts relative
to their intrinsic values. Securities include those that may be out of favor or underfollowed by analysts.
Using traditional risk-adjusted measures of performance (such as Sharpe
ratios), the performance of hedge funds has been very strong compared to that
140
Part One
Introduction
TABLE 5–11 Largest Hedge Funds by Fund Earnings, 2008–2009
Source: Bloomberg, 2009. www.bloomberg.com
Fund, Manager Name(s)
Fund Company
Appaloosa Investment I, David Tepper
Redwood Capital Master, Jonathan Kolatch
Glenview Institutional Partners, Larry Robbins
PARS IV, Changhong Zhu
Tennenbaum Opportunities V,
TCP Investment Committee
Kensington Global Strategies, Kenneth Griffin
BlueGold Global, Pierre Andurand, Dennis
Crema
Waterstone Market Neutral Master, Shawn
Bergerson
Canyon Value Realization, Mitchell Julis,
Joshua Friedman
Discovery Global Opportunity, Robert Citrone
Appaloosa Mgmt.
Redwood Captial Mgmt.
Glenview Capital Mgmt.
Pacific Investment Mgmt.
Tennenbaum Capital Partners
2009 Return
2008 Return
117.3%
69.1
67.1
61.0
58.5
⫺26.7%
⫺33.0
⫺49.0
⫺17.0
⫺51.2
Citadel Investment Group
BlueGold Capital Mgmt.
57.0
54.6
⫺55.0
209.4
Waterstone Capital Mgmt.
50.3
12.0
Canyon Partners
49.6
⫺29.0
Discovery Capital Mgmt.
47.9
⫺31.0
of traditional financial investments like stocks and bonds.8 Many hedge funds
posted strong returns during the early 2000s even as stock returns were plummeting. A few hedge funds even performed well during the financial crisis.
Table 5–11 lists the top hedge fund managers and their hedge fund company
by 2009 earnings. The average hedge fund lost 15.7 percent in 2008, the worst
performance on record. Nearly three-quarters of all hedge funds experienced
losses. Nevertheless, many funds outperformed many of the underlying markets
such as the S&P 500 index. Note that two of the hedge funds listed in Table 5–11
earned positive returns for 2008 as well as 2009 and one, BlueGold Global Fund,
earned 209.4 percent in 2008, a year where the S&P 500 index earned a return
of ⫺37.0 percent. Indeed, only three of the listed hedge funds performed worse
during the beginning of the financial crisis than the S&P 500 index. Performance improved significantly in 2009 with the average fund earning more than
20 percent for the year, the highest level since 2003 and the second best return in
10 years. However, the 2009 return on the S&P 500 index was 26.46 percent. Note
that while mutual fund performance is generally measured by returns relative to
some benchmark (and therefore can perform “well” even by losing 10 percent if
the benchmark loses 10.5 percent), performance of hedge funds is measured by
the growth in total assets managed. Assets under management in the hedge fund
industry fell by nearly 30 percent (to $1.5 trillion) in 2008. The decline was the
largest on record and was attributed to a combination of negative performance, a
surge in redemptions, and liquidations of funds.
Hedge fund performance continued to lag into the 2010s. In 2010, the average
hedge fund earned 10.3 percent. In 2011 the average was 5.0 percent, and in 2012
8
However, data deficiencies in the reporting and collection of hedge fund returns somewhat reduce confidence in all measures of hedge fund performance. Further, the inability to explain returns of individual
hedge funds with standard multifactor risk models leaves open the possibility that it is not possible to
properly measure the risk associated with at least some hedge fund strategies. If so, risk-adjusted returns
earned by hedge funds may be overstated.
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
141
TABLE 5–12 Largest Hedge Funds by Fund Earnings, 2011–2012
Source: Bloomberg, 2013, www.bloomberg.com
Fund, Manager Name(s)
Fund Company
Metacapital Mortgage Opportunities,
Deepak Narula
Pine River Fixed Income, Steve Kuhn
CQS Directional Opportunities, Michael Hintze
Pine River Liquid Mortgage, Steve Kuhn/Jiayi Chen
Omega Overseas Partners A, Leon Cooperman
Odey Europen, Crispin Odey
Marathon Securitized Credit, Bruce Richards/
Louis Hanover
Palomino, David Tepper
BTG Pactual GEMM, Team managed
Metacapital Management
37.8%
Pine River Capital Management
CQS
Pine River Capital Management
Omega Advisors
Odey Asset Management
Marathon Asset Management
32.9
28.9
28.0
24.4
24.1
24.0
4.8
⫺10.4
7.2
⫺1.4
⫺20.3
⫺4.2
Appaloosa Management
BTG Pactual Global Asset
Management
Third Point
24.0
23.1
⫺3.5
3.4
22.1
⫺2.3
Third Point Ultra, Daniel Loeb
2012 Return*
2011 Return
23.6%
* Through three quarters.
the average was 6.2 percent. The returns on the S&P 500 Index for these three
years were 15.1 percent, 2.0 percent, and 14.5 percent, respectively. As discussed
later, hedge funds generally charge fees of 2 percent of the money they manage
(compared to 1 percent for mutual funds) whether the fund makes money or not.
Further, managers may take up to 20 percent of any profit the hedge fund earns.
With performance as seen in the last four years, the question for the industry
is whether investors will start to lose faith in hedge funds and start liquidating
their sizable investments in these funds. In 2012, the industry saw net outflows
of funds invested of $31 billion. In August 2012, Reuters reported that one hedge
fund administrator’s redemption indicator hit its second-highest level of the year.
Also, major investors in John Paulson’s prominent but struggling hedge funds
(e.g., Citigroup’s private bank) had requested to redeem hundreds of millions of
dollars. Man Group, the world’s biggest publicly traded hedge fund, has seen its
stock drop by 40 percent through mid-2012 after its assets under management fell
by almost a third. Table 5–12 lists the top hedge fund managers and their hedge
fund company for 2012.
Despite their name, hedge funds do not always “hedge” their investments to
protect the fund and its investors against market price declines and other risks.
For example, while bond prices generally move in the same direction, the risk
in hedge funds is that bond prices may unexpectedly move faster in some markets than others. For example, in 1997 and 1998 computer models used by LTCM
detected a price discrepancy between U.S. Treasury markets and other bonds
(including high yield corporate bonds, mortgaged-backed securities, and European government bonds). LTCM consequently shorted U.S. Treasury securities
(betting their prices would fall) and took long positions in other types of bonds
(betting their prices would rise). However, unexpectedly, in 1998 large drops in
many foreign stock markets caused money to pour into the U.S. Treasury markets,
driving Treasury security prices up and yields down. This drop in U.S. Treasury
yields drove rates on mortgages down, which pushed down the prices of many
142
Part One
Introduction
mortgage-backed securities. Further, the flight to U.S. Treasury security markets
meant a drop in funds flowing into European bond markets and high-yield corporate bond markets. With all of their positions going wrong, LTCM experienced
huge losses.9
Similarly, the failures of two of Bear Stearns hedge funds (Bear Stearns HighGrade Structured Credit Fund and Bear Stearns High-Grade Structured Credit
Enhanced Leveraged Fund) were the result of managers’ failure to accurately predict how the subprime bond market would behave under extreme circumstances.
The market moved against them, and their investors lost $1.6 billion when the
funds, heavily invested in mortgage securities, collapsed in the summer of 2007.
The failures were the first sign of the upcoming financial crisis that would eventually cripple financial markets and the overall economy.
The strategy employed by the Bear Stearns funds was quite simple. Specifically,
the funds purchased collateralized debt obligations (CDOs) that paid an interest
rate over and above the cost of borrowing. Thus, every incremental unit of leverage added to the hedge funds’ total expected return. To capitalize on this, fund
managers used as much leverage as they could raise. Because the use of leverage
increased the portfolio’s exposure, fund managers purchased insurance on movements in credit markets. The insurance instruments, called credit default swaps
(CDSs), were designed to cover losses during times when credit concerns cause
the bonds to fall in value, effectively hedging away some of the risk. In instances
when credit markets (or the underling bonds’ prices) remained relatively stable,
or even when they behaved in line with historically based expectations, this strategy generated consistent, positive returns with very little deviation.
Unfortunately, as the problems with subprime debt began to unravel, the subprime mortgage-backed securities market behaved well outside of what the portfolio managers expected. This started a chain of events that imploded the funds.
The subprime mortgage market began to see substantial increases in delinquencies
from homeowners, which caused sharp decreases in the market values of these
types of bonds. Since the Bear Stearns hedge fund managers failed to expect these
sorts of extreme price movements, they failed to purchase sufficient credit insurance to protect against these losses. Because they had leveraged their positions
substantially, the funds began to experience large losses. The large losses made
the creditors who provided the debt financing uneasy. The lenders required Bear
Stearns to provide additional cash on their loans because the collateral (subprime
bonds) was rapidly falling in value. However, the funds had no cash holdings.
Thus, fund managers needed to sell bonds in order to generate cash. Quickly, it
became public knowledge that Bear Stearns was in trouble, and competing funds
moved to drive the prices of subprime bonds lower to force Bear Stearns’ into an
asset fire-sale. As prices on bonds fell, the fund experienced losses, which caused
it to sell more bonds, which lowered the prices of the bonds, which caused them to
sell more bonds. It did not take long before the funds had experienced a complete
loss of capital.
Fees on Hedge Funds
Hedge fund managers generally charge two type of fees: management fees and
performance fees. As with mutual funds, the management fee is computed as a
9
A major reason for LTCM’s large loss was that it was so highly leveraged compared to other funds.
LTCM was two to four times more leveraged than the typical fund.
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
143
percentage of the total assets under management and typically runs between 1.5
and 2.0 percent. Performance fees are unique to hedge funds. Performance fees
give the fund manager a share of any positive returns on a hedge fund. The average performance fee on hedge funds is approximately 20 percent but varies widely.
For example, Steven Cohen’s SAC Capital Partners charges a performance fee of
50 percent. Performance fees are paid to the hedge fund manager before returns
are paid to the fund investors. Hedge funds often specify a hurdle rate, which is
a minimum annualized performance benchmark that must be realized before a
performance fee can be assessed. Further, a high-water mark is usually used for
hedge funds in which the manager does not receive a performance fee unless the
value of the fund exceeds the highest net asset value it has previously achieved.
High-water marks are used to link the fund manager’s incentives more closely to
those of the fund investors and to reduce the manager’s incentive to increase the
risk of trades.
Offshore Hedge Funds
Hedge funds that are organized in the United States are designated as domestic
hedge funds. These funds require investors to pay income taxes on all earnings from
the hedge fund. Funds located outside the United States and structured under foreign laws are designated as offshore hedge funds. Many offshore financial centers
encourage hedge funds to locate in their countries. The major centers include the
Cayman Islands, Bermuda, Dublin, and Luxembourg. The Cayman Islands is estimated to be the location of approximately 75 percent of all hedge funds. Offshore
hedge funds are regulated in that they must obey the rules of the host country. However, the rules in most of these countries are not generally burdensome and provide
anonymity to fund investors. Further, offshore hedge funds are not subject to U.S.
income taxes on distributions of profit or to U.S. estate taxes on fund shares.
When compared to domestic hedge funds, offshore hedge funds have been
found to trade more intensely, due to the low or zero capital gains tax for offshore
funds. Further, offshore hedge funds tend to engage less often in positive feedback
trading (rushing to buy when the market is booming and rushing to sell when
the market is declining) than domestic hedge funds. Finally, offshore hedge funds
have been found to herd (mimic each other’s behavior when trading while ignoring information about the fundamentals of valuation) less than domestic hedge
funds. Many hedge fund managers maintain both domestic and offshore hedge
funds. Given the needs of their client investors, hedge fund managers want to
have both types of funds to attract all types of investors.
Regulation of Hedge Funds
While mutual funds are very highly regulated, hedge funds have generally been
unregulated. Mutual funds in the United States are required to be registered with
the SEC. Although hedge funds fall within the same statutory category as mutual
funds, they operate under two exemptions from registration requirements as set
forth in the Investment Company Act of 1940. First, funds are exempt if they have
less than 100 investors. Second, funds are exempt if the investors are “accredited.”
To comply with SEC exemptions, hedge funds are also sold only via private placements. Thus, hedge funds may not be offered or advertised to the general investing public.
In 2010, the Wall Street Reform and Consumer Protection Act required hedge
fund advisors with private pools of capital exceeding $100 million in assets to
144
Part One
Introduction
register with the SEC as investment advisors and become subject to all rules which
apply to registered advisors by July 2011. Thus, previous exemptions from registration provided under the Investment Company Act of 1940 no longer apply to
most hedge fund advisors. Under the act, hedge fund managers who have less
than $100 million in assets under management will be overseen by the state where
the manager is domiciled and become subject to state regulation. This registration
subjects the hedge funds to periodic inspections by SEC examiners. Further, hedge
funds are required to report information to the SEC about their trades and portfolios that is “necessary for the purpose of assessing systemic risk posed by a private
fund.” The data is kept confidential, and can be shared only with the Financial
Stability Oversight Council that the legislation set up to monitor potential shocks
to the economic system. Finally, should the government determine a hedge fund
has grown too large or risky, the hedge fund is placed under the supervision of the
Federal Reserve. Thus, while the act requires large hedge funds to be registered
with the SEC, the regulations imposed on hedge funds continue to be much less
onerous than those imposed on mutual funds.
Nevertheless, hedge funds are prohibited from abusive trading practices and a
number got mixed up in the scandals plaguing the mutual fund industry in the
2000s. For example, Canary Capital Partners and its managers agreed to pay $30
million from its illicit profits as well as a $10 million penalty to the SEC to settle
allegations that it engaged in illegal trading practices with mutual fund companies, including making deals after the market had closed and promising to make
substantial investments in various funds managed by the mutual funds. In March
2007, the SEC charged 14 defendants in a scheme involving insiders at UBS Securities, Morgan Stanley, and several hedge funds and hedge fund managers. The SEC
claimed that the defendants made $15 million in illicit profits through thousands of
illegal trades, using inside information misappropriated from UBS. Just two months
prior to this announcement, regulators announced an investigation of UBS and
other banks that leased office space to hedge fund traders. Regulators stated a concern about the relationship between the banks and their hedge fund “hotel guests,”
looking at whether the banks might be using the real estate relationships as a way to
entice hedge funds to do business with them, possibly at the expense of the funds’
investors. Specifically, there was an investigation into whether hedge funds located
in bank buildings were paying higher than normal trading fees to banks to compensate them for the office space and failing to disclose this expense to investors.
More recently, the late 2000s saw two highly publicized scandals associated
with hedge funds. The first was that of Bernard L. Madoff Investment Securities.
The Madoff investment scandal occurred after the discovery that the asset management business of former NASDAQ chairman Bernard Madoff was actually a
giant “Ponzi” scheme. According to a federal criminal complaint, client statements
showing $65 billion in stock holdings were fictitious, and there was no indication
that any stocks were purchased since the mid-1990s. Alerted by his sons, federal
authorities arrested Madoff on December 11, 2008. The firm was placed in liquidation and a trustee was appointed on December 15, 2008, after Bernard Madoff confessed to having stolen customer property over a period of many years. On March
12, 2009, Madoff pled guilty to 11 felonies and admitted to operating what has
been called the largest investor fraud ever committed by an individual. On June
29, 2009, he was sentenced to 150 years in prison with restitution of $170 billion.
Although Madoff did not operate as a hedge fund, he operated through various
funds of hedge funds.
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
145
Second is the case of Galleon Group LLC, one of the largest hedge fund management firms in the world before announcing its closure in October 2009. The
firm was at the center of a 2009 insider trading scandal that resulted in investors
pulling capital from the firm rapidly. Twenty people, including Galleon Group
LLC co-founder Raj Rajaratnam, were criminally charged in what federal authorities called the biggest prosecution of alleged hedge fund insider trading in the
United States. Prosecutors said they had evidence from wiretaps, trading records,
and cooperating witnesses to prove widespread trafficking in illegal insider information, including an insider trading operation that paid sources for nonpublic
information, that netted the hedge fund more than $20 million.
1. What is the difference between a mutual fund and a hedge fund?
2. What are the performance fees charged by hedge funds?
3. How is the regulatory status of hedge funds changing?
Summary
This chapter provided an overview of the mutual fund and hedge fund industries.
Mutual funds and hedge funds pool funds from individuals and corporations and
invest in diversified asset portfolios. Given the tremendous growth in the market
values of financial assets—such as equities—from 1992 through 2007 and the costeffective way in which these funds allow investors to participate in these markets, mutual funds and hedge funds have grown tremendously in size, number of
funds, and number of shareholders.
Questions
and Problems
1. What is a mutual fund? In what sense is it a financial institution?
2. What are money market mutual funds? In what assets do these funds typically
invest? What factors have caused the strong growth in this type of fund since
the late 1970s?
3. What are long-term mutual funds? In what assets do these funds usually invest?
What factors caused the strong growth in this type of fund from 1992 through
2007, the slowdown in growth in 2007, 2008, and the return to growth after 2008?
4. Using the data in Table 5–2, discuss the growth and ownership holdings over
the last 32 years of long-term funds versus short-term funds.
5. Why did the proportion of equities in long-term funds increase from
38.3 percent in 1990 to more than 70 percent by 2000 and then decrease to
54 percent in 2012? How might an investor’s preference for a mutual funds
objective change over time?
6. How does the risk of short-term funds differ from the risk of long-term funds?
7. What are the economic reasons for the existence of mutual funds; that is, what
benefits do mutual funds provide for investors? Why do individuals rather
than corporations hold most mutual funds shares?
8. What are the principal demographics of household owners who own mutual
funds? What are the primary reasons why household owners invest in mutual
funds?
9. What change in regulatory guidelines occurred in 2009 that had the primary
purpose of giving investors a better understanding of the risks and objectives
of a fund?
www.mhhe.com/saunders8e
Concept
Questions
www.mhhe.com/saunders8e
146
Part One
Introduction
10. What are the three possible components reflected in the return an investor
receives from a mutual fund?
11. How is the net asset value (NAV) of a mutual fund determined? What is meant
by the term marked-to-market daily?
12. Suppose today a mutual fund contains 2,000 shares of J.P. Morgan Chase, currently trading at $46.75; 1,000 shares of Walmart, currently trading at $70.10;
and 2,500 shares of Pfizer, currently trading at $27.50. The mutual fund has no
liabilities and 10,000 shares outstanding held by investors.
a. What is the NAV of the fund?
b. Calculate the change in the NAV of the fund if tomorrow J.P. Morgan’s
shares increase to $50, Walmart’s shares increase to $73, and Pfizer’s shares
increase to $30.
c. Suppose that today 1,000 additional investors buy one share each of the
mutual fund at the NAV of $23.235. This means that the fund manager has
$23,235 additional funds to invest. The fund manager decides to use these
additional funds to buy additional shares in J.P. Morgan Chase. Calculate
tomorrow’s NAV given the same rise in share values as assumed in part (b).
13. A mutual fund owns 300 shares of General Electric, currently trading at $22,
and 400 shares of Microsoft Inc., currently trading at $28. The fund has 1,000
shares outstanding.
a. What is the net asset value (NAV) of the fund?
b. If investors expect the price of General Electric shares to increase to $26 and
the price of Microsoft shares to decrease to $20 by the end of the year, what
is the expected NAV at the end of the year?
c. Assume that the expected price of the General Electric shares is realized at
$26. What is the maximum price decrease that can occur to the Microsoft
shares to realize an end-of-year NAV equal to the NAV estimated in part (a)?
14. What is the difference between open-end and closed-end mutual funds?
Which type of fund tends to be more specialized in asset selection? How does
a closed-end fund provide another source of return from which an investor
may either gain or lose?
15. Open-end fund A owns 165 shares of AT&T valued at $35 each and 50 shares
of Toro valued at $45 each. Closed-end fund B owns 75 shares of AT&T and
120 shares of Toro. Each fund has 1,000 shares of stock outstanding.
a. What are the NAVs of both funds using these prices?
b. Assume that in one month the price of AT&T stock has increased to $36.25
and the price of Toro stock has decreased to $43.375. How do these changes
impact the NAV of both funds? If the funds were purchased at the NAV
prices in part (a) and sold at month end, what would be the realized returns
on the investments?
c. Assume that another 155 shares of AT&T are added to fund A. The funds
needed to buy the new shares are obtained by selling 676 more shares
in fund A. What is the effect on fund A’s NAV if the stock prices remain
unchanged from the original prices?
16. What is the difference between a load fund and a no-load fund? Is the argument that load funds are more closely managed and therefore have higher
returns supported by the evidence presented in Table 5–6?
17. What is a 12b–1 fee? Suppose you have a choice between a load fund with
no annual 12b–1 fee and a no-load fund with an annual 12b–1 fee of 25 basis
points. How would the length of your expected investment horizon, or holding period, influence your choice between these two funds?
Chapter 5
Financial Services: Mutual Funds and Hedge Funds
147
18. Suppose an individual invests $10,000 in a load mutual fund for two years.
The load fee entails an up-front commission charge of 4 percent of the amount
invested and is deducted from the original funds invested. In addition, annual
fund operating expenses (or 12b–1 fees) are 0.85 percent. The annual fees are
charged on the average net asset value invested in the fund and are recorded
at the end of each year. Investments in the fund return 5 percent each year
paid on the last day of the year. If the investor reinvests the annual returns
paid on the investment, calculate the annual return on the mutual fund over
the two-year investment period.
19. Who are the primary regulators of the mutual fund industry? How do their
regulatory goals differ from those of other types of financial institutions?
20. What is a hedge fund and how is it different from a mutual fund?
21. What are the different categories of hedge funds?
22. What types of fees do hedge funds charge?
23. What is the difference between domestic hedge funds and offshore hedge
funds? Describe the advantages of offshore hedge funds over domestic hedge
funds.
Web Questions
www.mhhe.com/saunders8e
24. Go to the Fidelity Investments website and look up the annual 1-, 5-, and
10-year returns on Fidelity Select Biotechnology Fund using the following
steps. The website is www.fidelity.com. Click on “Investment Products.”
Click on “Mutual Funds.” Click on “Fidelity Funds.” Click on “Browse all
Fidelity Funds.” Click on “S.” Click on “Select Biotechnology Portfolio.” This
will bring the file onto your computer that contains the relevant data.
25. Go to the Investment Company Institute website and look up the most recent
data on the asset values and number of short-term and long-term mutual
funds using the following steps. The website is www.ici.org. Click on “Publications.” Click on “Fact Books.” Click on the most recent year for “XXXX
Investment Company Fact Book.” Go to “Data Tables.” This section contains
the relevant data. The data on asset values and number of mutual funds are
among the first few pages. How have these values increased since those for
2012 reported in Table 5–1?
Chapter Six
Financial Services:
Insurance
INTRODUCTION
www.metlife.com
www.allstate.com
www.aig.com
148
Insurance services offered by FIs protect individuals and corporations (policyholders) from adverse events. By accepting premiums, FIs that offer insurance services promise policyholders compensation if certain specified events occur. These
policies represent financial liabilities to the insurance company. With the premiums collected, insurance companies invest in financial securities such as corporate bonds and stocks. Insurance services are classified into two major groups: life
and property–casualty. Life insurance provides protection against the possibility
of untimely death, illnesses, and retirement. Property–casualty insurance protects
against personal injury and liability such as accidents, theft, and fire. Many FIs
(e.g., MetLife and Allstate) offer both life and property–casualty services. Further,
many FIs that offer insurance services also sell a variety of investment products in
a similar fashion to other financial service firms, such as mutual funds (Chapter 5)
and banking services (Chapter 2).
The financial crisis showed just how much risk insurance companies can present to FIs and the global financial system. Specifically, as the subprime mortgage
market began to fail in the summer of 2008, subprime mortgage pools, and the
securities written on them, ended up falling precipitously in value as foreclosures and defaults rose on the underlying mortgage pools. Many credit default
swaps (CDSs) were written on these subprime mortgage securities. CDS contracts
offer credit protection (insurance) against default on the mortgage securities. As
mortgage security losses started to rise, buyers of the CDS contracts wanted to
be paid for these losses. AIG was a major writer of these CDS securities. When
mortgage-backed securities started to fall in value, AIG had to make good on billions of dollars of credit default swaps. Soon it became clear that AIG was not
going to be able to cover its credit default swap market losses. The result was a
significant increase in the risk exposure of banks, investment banks, and insurance companies that had purchased AIG CDS insurance contracts. Indeed, the reason the federal government stepped in and bailed out AIG was that the insurer
was a dominant player in the CDS market. Had AIG defaulted, every FI that had
bought a CDS contract from the company would have suffered substantial losses.
In this chapter we describe the main features of life insurance and property–
casualty insurance companies, concentrating on (1) the size, structure, and composition of the industry in which they operate, (2) balance sheets and recent
Chapter 6
Financial Services: Insurance
149
trends, and (3) regulations for each. We also look at global competition and trends
in this industry.
LIFE INSURANCE
Life insurance allows individuals and their beneficiaries to protect against losses
in income through premature death or retirement. By pooling risks, life insurance
transfers income-related uncertainties from the insured individual to a group.
Size, Structure, and Composition of the Industry
In the 2010s, the United States had approximately 1,000 life insurance companies
compared with more than 2,300 in 1988. The aggregate assets of life insurance
companies were $5.6 trillion in 2012, compared with $1.1 trillion in 1988. The four
largest life insurance companies, in terms of total assets (listed in Table 6–1) wrote
27 percent of the industry’s $676.4 billion new life insurance premium business in
2011. Interestingly, many of these insurance policies were sold through commercial
banks. For example, in 2012 commercial banks sold 12.8 percent of all fixed annuity insurance contracts and 12.3 percent of all variable rate insurance contracts.
Although not to the extent seen in the banking industry, the life insurance
industry has seen some major mergers in recent years (e.g., SunAmerica and AIG,
Prudential and Cigna, and MetLife and American Life Insurance) as competition
within the industry and from other FIs has increased. In addition, many of the
largest insurance companies, such as Metropolitan and Prudential, have converted to stockholder-controlled companies. In so doing, they gain access to the
equity markets in order to realize additional capital for future business expansions and to compete with the rapidly consolidating banking industry. Since a
mutual company is owned by its policyholders, the existing capital and reserves
(equal to accumulated past profits) have to be distributed to the insurer’s policyholders. Table 6–1 lists the form of ownership for the top 10 life insurers in the
United States, while Figure 6–1 illustrates the difference between a mutual insurer
and a stock insurance company.
While life insurance may be the core activity area, modern life insurance companies also sell annuity contracts, manage pension plans, and provide accident
and health insurance (Figure 6–2 shows the distribution of premiums written for
the various lines of insurance in 2011). We discuss these different activity lines in
the following sections.
TABLE 6–1
Biggest Life
Insurers
Sources: Best’s Review, July
2012; and authors’ research.
www.ambest.com
Rank
1
2
3
4
5
6
7
8
9
10
Insurance Company
Metropolitan Life
Prudential of America
Manulife Financial
SunAmerica Financial Group
Teachers Insurance and Annuity
New York Life
Hartford Life
Northwestern Mutual
ING Group
Aegon USA Inc.
Form of Ownership
Assets (billions)
Stock
Stock
Stock
Stock
Stock
Mutual
Stock
Mutual
Stock
Stock
$612.8
424.1
243.3
233.9
229.8
228.3
218.5
189.7
181.7
180.2
150
Part One
Introduction
FIGURE 6–1
Mutual Insurer
Mutual versus
Stock Insurance
Companies
Stock Insurer
Accumulated profits
owned by stockholders
s
right
rship
Stockholders
wne
Accumulated
profits owned by
policyholders
Mutual
Insurance
Company
O
Policy and
ownership
rights
Policy
dividends
Stock
Insurance
Company
Policyholders
k
Stoc
ends
divid
Policy
rights
Policyholders
One problem that naturally faces life insurance companies (as well as property–
casualty insurers) is the so-called adverse selection problem. Adverse selection is
a problem in that customers who apply for insurance policies are more likely to
be those most in need of insurance (i.e., someone with chronic health problems is
more likely to purchase a life insurance policy than someone in perfect health).
Thus, in calculating the probability of having to pay out on an insurance contract
and, in turn, determining the insurance premium to charge, insurance companies’
use of health (and other) statistics representing the overall population may not be
appropriate (since the insurance company’s pool of customers is more prone to
health problems than the overall population). Insurance companies deal with the
adverse selection problem by establishing different pools of the population based
on health and related characteristics (such as income). By altering the pool used
to determine the probability of losses to a particular customer’s health characteristics, the insurance company can more accurately determine the probability of
having to pay out on a policy and can adjust the insurance premium accordingly.
As the various types of insurance policies and services offered are described
below, notice that some policies (such as universal life policies and annuities) provide not only insurance features but also savings components. For example, universal life policy payouts are a function of the interest earned on the investment of
the policyholder’s premiums.
Types of Life Insurance
The four basic classes or lines of life insurance are distinguished by the manner
in which they are sold or marketed to purchasers. These classes are (1) ordinary
life, (2) group life, (3) industrial life, and (4) credit life. Among the life insurance
FIGURE 6–2
Distribution of
Life Insurance
Premiums Written
Source: Best’s Review,
September 2012.
www.ambest.com
Other* 0.2%
Group life 4.7%
Ordinary
life
19.3%
Accident
and health
26.3%
*Includes credit life and industrial life
Group annuities 18.1%
Ordinary annuities 31.4%
Chapter 6
Financial Services: Insurance
151
policies in force in the United States, ordinary life accounted for approximately
79.9 percent, group life for 19.2 percent, and industrial life and credit life together
for less than 1 percent of the $163.8 billion in contracts written in 2011.
Ordinary Life Ordinary life insurance involves policies marketed on an individual basis, usually in units of $1,000, on which policyholders make periodic
premium payments. Despite the enormous variety of contractual forms, there are
essentially five basic contractual types. The first three are traditional forms of ordinary life insurance, and the last two are newer contracts that originated in the 1970s
and 1980s as a result of increased competition for savings from other segments of
the financial services industry. The three traditional contractual forms are term life,
whole life, and endowment life. The two newer forms are variable life and universal life. The key features of each of these contractual forms are as follows:
• Term life. A term life policy is the closest to pure life insurance, with no savings
element attached. Essentially, the individual receives a payout contingent on
death during the coverage period. The term of coverage can vary from as little
as 1 year to 40 years or more.
• Whole life. A whole life policy protects the individual over an entire lifetime. In
return for periodic or level premiums, the individual’s beneficiaries receive the
face value of the life insurance contract on death. Thus, there is certainty that
if the policyholder continues to make premium payments, the insurance company will make a payment—unlike term insurance. As a result, whole life has a
savings element as well as a pure insurance element.
• Endowment life. An endowment life policy combines a pure (term) insurance element with a savings element. It guarantees a payout to the beneficiaries of the
policy if death occurs during some endowment period (e.g., prior to reaching
retirement age). An insured person who lives to the endowment date receives
the face amount of the policy.
• Variable life. Unlike traditional policies that promise to pay the insured the fixed
or face amount of a policy if a contingency arises, variable life insurance invests
fixed premium payments in mutual funds of stocks, bonds, and money market instruments. Usually, policyholders can choose mutual fund investments
to reflect their risk preferences. Thus, variable life provides an alternative way
to build savings compared with the more traditional policies such as whole life
because the value of the policy increases or decreases with the asset returns of
the mutual fund in which the premiums are invested.
• Universal life and variable universal life. Universal life allows both the premium
amounts and the maturity of the life contract to be changed by the insured,
unlike traditional policies that maintain premiums at a given level over a fixed
contract period. In addition, for some contracts, insurers invest premiums in
money, equity, or bond mutual funds—as in variable life insurance—so that the
savings or investment component of the contract reflects market returns. In this
case, the policy is called variable universal life.
Group Life Insurance Group life insurance covers a large number of insured persons under a single policy. Usually issued to corporate employers, these policies
may be either contributory (where both the employer and employee cover a share
of the employee’s cost of the insurance) or noncontributory (where the employee
does not contribute to the cost of the insurance) for the employees. Cost economies represent the principal advantage of group life over ordinary life policies.
152
Part One
Introduction
Cost economies result from mass administration of plans, lower costs for evaluating individuals through medical screening and other rating systems, and reduced
selling and commission costs.
Industrial Life Industrial life insurance currently represents a very small area of
coverage. Industrial life usually involves weekly payments directly collected by
representatives of the companies. To a large extent, the growth of group life insurance has led to the demise of industrial life as a major activity class.
Credit Life Credit life insurance is sold to protect lenders against a borrower’s
death prior to the repayment of a debt contract such as a mortgage or car loan.
Usually, the face amount of the insurance policy reflects the outstanding principal
and interest on the loan.
Other Life Insurer Activities
Three other major activities of life insurance companies involve the sale of annuities, private pension plans, and accident and health insurance.
Annuities Annuities represent the reverse of life insurance activities. Whereas
life insurance involves different contractual methods of building up a fund, annuities involve different methods of liquidating a fund, such as paying out a fund’s
proceeds. As with life insurance contracts, many different types of annuity contracts have been developed. Specifically, they can be sold to an individual or a
group and on a fixed or a variable basis by being linked to the return on some
underlying investment portfolio. Individuals can purchase annuities with a single
payment or with payments spread over a number of years. The annuity builds up
a fund whose returns are tax deferred. That is, they are not subject to capital gains
taxes on their investments. Payments may be structured to start immediately, or
they can be deferred (at which time taxes are paid based on the income tax rate of
the annuity receiver). These payments may cease on death or continue to be paid
to beneficiaries for a number of years after death.
While the traditional life insurance products described remain an important part
of life insurance firm business, these lines (whether measured by premium income
or by assets) are no longer the primary business of many companies in the life
insurance industry. Rather, the major area of business for life insurance companies
has shifted to annuities. Annuity sales in 2011 topped $334.8 billion ($212.4 billion
of which were ordinary annuities), compared with $26 billion in 1996. Further, this
is more than twice the $163.8 billion in sales for the traditional life insurance lines.
Private Pension Plans Insurance companies offer many alternative pension
plans to private employers in an effort to attract this business from other financial
service companies, such as commercial banks and securities firms. Some of their
innovative pension plans are based on guaranteed investment contracts (GICs).
This means the insurer guarantees not only the rate of interest credited to a pension plan over a given period—for example, five years—but also the annuity rates
on beneficiaries’ contracts. Other plans include immediate participation and separate account plans that follow more aggressive investment strategies than traditional life insurance, such as investing premiums in special-purpose equity mutual
funds. In 2012, life insurance companies were managing more than $2.6 trillion in
pension plan assets, equal to approximately 40 percent of all private pension plans.
Accident and Health Insurance While life insurance protects against mortality
risk, accident and health insurance protect against morbidity, or ill health, risk.
More than $177.8 billion in premiums were written by life and health companies
Chapter 6
Financial Services: Insurance
153
in the accident–health area in 2011. The major activity line is group insurance,
providing health insurance coverage to corporate employees. Life insurance companies write more than 50 percent of all health insurance premiums.
Balance Sheet and Recent Trends
Assets
policy loans
Loans made by an
insurance company
to its policyholders
using their policies as
collateral.
TABLE 6–2
Because of the long-term nature of their liabilities (as a result of the long-term
nature of life insurance policyholders’ claims) and the need to generate competitive returns on the savings elements of life insurance products, life insurance
companies concentrate their asset investments at the longer end of the maturity
spectrum (e.g., bonds, equities, and government securities). Look at Table 6–2,
where we show the distribution of life insurance companies’ assets.
As you can see, in 2012, 11.7 percent of assets were invested in government securities, 68.9 percent in corporate bonds and stocks, and 6.2 percent in mortgages,
with other loans—including policy loans (loans made to policyholders using their
policies as collateral)—making up the balance. While commercial banks are the
major issuers of new mortgages (sometimes keeping the mortgages on their books
and sometimes selling them to secondary market investors), insurance companies
hold mortgages as investment securities. That is, they purchase many mortgages
in the secondary markets (see Chapters 25 and 26). The major trends have been a
long-term increase in the proportion of bonds and equities1 and a decline in the
Distribution of Assets of U.S. Life Insurance Companies
Sources: American Council of Life Insurance, Life Insurance Fact Book, 1994; Best’s Review, October 1996; and Federal Reserve Bulletin, various issues.
www.federalreserve.gov
Year
1917
1920
1930
1940
1950
1960
1970
1980
1990
1995
2000
2005
2007
2008
2009
2010
2012
Total Assets
(billions)
$
Government
Securities
5.9
7.3
18.9
30.8
64.0
119.6
207.3
479.2
1,408.2
2,131.9
3,133.9
4,350.7
4,949.7
4,515.5
4,749.4
5,176.3
5,561.6
9.6%
18.4
8.0
27.5
25.2
9.9
5.3
6.9
15.0
18.6
9.3
10.6
10.0
11.5
11.5
12.5
11.7
Corporate Securities
Bonds
Stocks
Mortgages
Policy
Loans
Miscellaneous
U.S. Assets
33.2%
26.7
26.0
28.1
36.3
39.1
35.3
37.5
41.4
41.4
39.1
44.0
37.6
40.3
40.2
39.2
38.6
1.4%
1.0
2.8
2.0
3.3
4.2
7.4
9.9
9.1
17.4
31.5
29.2
33.4
24.9
27.2
30.1
30.3
34.0%
33.4
40.2
19.4
25.1
34.9
35.9
27.4
19.2
9.9
7.5
6.6
6.6
7.6
7.0
6.1
6.2
13.6%
11.7
14.9
10.0
3.8
4.4
7.8
8.6
4.4
4.5
3.2
2.5
2.9
3.6
3.5
2.7
2.6
5.2%
6.5
5.2
6.3
4.1
4.4
5.3
6.6
7.8
6.3
9.4
7.1
9.5
12.1
10.6
9.4
10.6
Note: Beginning with 1962, these data include the assets of separate accounts.
1
The bull market of the 1980s and 1990s probably constitutes a major reason for the large percentage
of assets invested in equities. Conversely, the large drop in equity prices during the financial crisis explains
the reduction in the percentage of stocks held by insurance companies in the late 2000s.
154
Part One
Introduction
TABLE 6–3
Life Insurance
Industry Balance
Sheet, 2012 (in
billions of dollars)
Percent of
Total Assets
Assets
Source: Reprinted with permission from Best’s Aggregates & Averages, Life-Health,
2012, p. 2. www.ambest.com
Bonds
Preferred stock
Common stock
Mortgage loans
Real estate
Contract loans
Cash and short-term investments
Other invested assets
Premiums due
Accrued investment income
Separate account assets
Other assets
$2,611.5
8.5
73.5
332.9
20.9
128.8
99.0
184.2
24.8
35.1
1,849.4
114.3
47.6%
0.2
1.3
6.1
0.4
2.3
1.8
3.4
0.5
0.6
33.7
2.1
Total assets
$5,482.9
100.0%
Net policy reserves
Deposit-type contracts
Policy claims
Other liabilities
Separate account business
Total capital and surplus
$2,609.3
275.3
43.6
390.2
1,854.4
319.1
47.6%
5.0
0.8
7.1
33.7
5.8
Total liabilities and capital/surplus
$5,482.9
100.0%
Liabilities and Capital/Surplus
proportion of mortgages in the balance sheet. Thus, insurance company managers
must be able to measure and manage the credit risk, interest rate risk, and other
risks associated with these securities.
Liabilities
policy reserves
A liability item for
insurers that reflects
their expected payment commitment
on existing policy
contracts.
surrender value of
a policy
The cash value of a
policy received from
the insurer if a policyholder surrenders the
policy before maturity.
The cash surrender
value is normally only
a portion of the contract’s face value.
The aggregate balance sheet for the life insurance industry at the beginning of
2012 is shown in Table 6–3. Looking at the liability side of the balance sheet, we
see that $2.609 trillion, or 47.6 percent, of total liabilities and capital are net policy
reserves (the expected payment commitment on existing policy contracts). These
reserves are based on actuarial assumptions regarding the insurers’ expected
future liability commitments to pay out on present contracts, including death
benefits, matured endowments (lump sum or otherwise), and the cash surrender
values of policies (the cash value paid to the policyholder if the policy is surrendered before it matures). Even though the actuarial assumptions underlying
policy reserves are normally very conservative, unexpected fluctuations in future
required payouts can occur; thus, underwriting life insurance is risky. For example, mortality rates—and life insurance payouts—might unexpectedly increase
above those defined by historically based mortality tables as a result of a catastrophic epidemic illness such as AIDS or widespread influenza. To meet unexpected future losses, the life insurer holds a capital and surplus reserve fund with
which to meet such losses (and reduce insolvency risk). The capital and surplus
reserves of life insurers in 2012 were $319.1 billion, or 5.8 percent of total assets.2
2
An additional line of defense against unexpected underwriting losses is the insurer’s investment income
from its asset portfolio plus any new premium income flows.
Chapter 6
separate accounts
Annuity programs
sponsored by life
insurance companies
in which the payoff
on the policy is linked
to the assets in which
policy premiums are
invested.
Financial Services: Insurance
155
Separate account business represented 33.7 percent of total liabilities and capital
in 2012. A separate account is a fund established and held separately from the
insurance company’s other funds. These funds may be invested without regard to
the usual diversification restrictions; that is, they may be invested in all stocks, all
bonds, and so forth. Note that these assets are also listed separately on the asset
side of the balance sheet. Separate account assets are 33.7 percent of total assets.
The payoff on the life insurance policy thus depends on the return on the funds in
the separate account. Another important life insurer liability, GICs (5.0 percent of
total liabilities and capital), are short- and medium-term debt instruments sold by
insurance companies to fund their pension plan business (see deposit-type contracts in Table 6–3).
Recent Trends
The life insurance industry was very profitable in the early and mid-2000s, with
over $500 billion in premiums and annuities recorded annually in 2004 through
2009. Net income topped $34 billion in 2006, up 6.5 percent from 2005. Credit markets continued to be strong, and capital levels for the industry remained strong.
However, the financial crisis took a toll on this industry. The value of stocks and
bonds in insurers’ asset portfolios dropped as financial markets deteriorated. Further, losses were experienced on life insurers’ positions in commercial mortgagebacked securities, commercial loans, and lower-grade corporate debt as bond
default rates increased and mortgage markets froze. Lower equity market values also reduced asset-based fees earned from balances on equity-linked products, such as variable annuities. As a result, life insurers with large proportions of
separate-account assets were particularly hard hit with declining earnings from
equities. Furthermore, as investors fled to the safety of government bonds during the financial crisis, government bond yields (which are generally a significant
source of investment income for life insurers) fell. Additionally, historically low
short-term interest rates prevented life insurers from lowering minimum rates on
new policies, which encouraged higher surrender rates on existing policies that
were already at minimum credit rates. The results were huge losses in 2008 for the
industry. Realized and unrealized capital losses from bonds, preferred stocks, and
common stocks topped $35 billion, representing more than an 875 percent drop
from 2007. Net investment income also fell by 3.5 percent in 2008 from 2007. The
result was that net after-tax income for the year was ⫺$51.8 billion, $83.7 billion
less than in 2007.
The large drop in the value of stocks and bonds that the insurers held made
it harder for the companies to pay out money due to their policyholders. In late
2008/early 2009, insurance company reserves began to dwindle to dangerous levels. Further, the falling value of their assets made it harder for the insurers’ to raise
capital. As a result, the Treasury Department decided to extend bailout funds to a
number of struggling life insurance companies, the most notable being $127 billion
to AIG (including $45 billion from TARP, $77 billion to purchase collateralized
debt and mortgage backed securities, and a $44 billion bridge loan). Other life
insurers receiving TARP funds included Hartford Financial Services Group,
Prudential Financial, Lincoln National, and Allstate. Events associated with the
financial crisis continued to be felt in 2009. Premium income fell by $120 billion
(19 percent) from 2008 levels, while net realized capital for the industry fell by
$28.7 billion. However, late 2009 saw some improvements for the industry. Overall, the industry saw an increase in total assets of more than $200 billion and net
156
Part One
Introduction
income returned to a positive $21.1 billion. Further, the industry continued to
pay dividends of $15.0 billion in 2009. Premiums continued to recover in 2010
and 2011 as annuity and most types of life insurance premiums increased.
The 2011 premiums of $676.4 billion fell just short of the pre-crisis (2007) level,
$677.2 billion. Further, net income increased to $28.0 billion in 2010 before dropping to $14.4 billion in 2011. The 2011 drop was the result of accounting changes
and a number of one-time events involving specific companies rather than industry weakness. However, challenges remain for the industry. Interest rates remain
at historical lows, which increases the risk of spread compression for existing contracts and hampers the sale of new fixed annuity and universal life insurance
contracts. Further, equity markets remain volatile and new regulations (see below)
could adversely affect profits.
Regulation
McCarran-Ferguson
Act of 1945
Legislation confirming the primacy of
state over federal
regulation of insurance companies.
www.naic.org
insurance
guarantee funds
Funds consisting of
required contributions from within
state insurance companies to compensate
insurance company
policyholders if there
is a failure.
An important legislation affecting the regulation of life insurance companies is
the McCarran-Ferguson Act of 1945, which confirms the primacy of state over
federal regulation of insurance companies. Thus, unlike the depository institutions we discussed in Chapter 2, which can be chartered either at the federal or
the state level, chartering of life insurers is done entirely at the state level. In addition to chartering, state insurance commissions supervise and examine insurance
companies by using a coordinated examination system developed by the National
Association of Insurance Commissioners (NAIC).
In 2009, the U.S. Congress considered establishing an optional federal insurance
charter. The move behind such a charter picked up steam following the failure of
the existing state by state regulatory system to act in preventing the problems at
insurance giant AIG from becoming a systemic risk to the national economy. Those
in favor of an optional federal insurance charter noted that under the current state
by state system, insurers face obstacles such as inconsistent regulations, barriers
to innovation, conflicting agent licensing, and education requirements. While the
House version of the 2010 Financial Services Regulatory Overhaul Bill (approved
in December 2009) contained no provision for federal regulation of insurance companies, Financial Services Chairman Barney Frank stated that this would still be a
possibility as the bill moved through the regulatory process toward final passage.
The final version of the overhaul bill, the Wall Street Reform and Consumer
Protection Act of 2010, established the Federal Insurance Office (FIO) that reports
to Congress and the president on matters pertaining to the insurance industry.
While the industry’s main regulator continues to be the states in which firms operate, the FIO has the authority to monitor the insurance industry, identify regulatory gaps or systemic risk, deal with international insurance matters, and monitor
the extent to which underserved communities have access to affordable insurance
products. The Wall Street Reform and Consumer Protection Act also called for
the establishment of the Financial Stability Oversight Council (FSOC), which is
charged with designating any financial institution (including insurance companies) that presents a systemic risk to the economy and subjecting them to greater
regulation.
In addition to supervision and examination, states promote life insurance guarantee funds. Unlike banks and thrifts, life insurers have no access to a federal
guarantee fund (although, as mentioned above, during the financial crisis the federal government took the unprecedented step of bailing out several major insurance companies). These state guarantee funds differ in a number of important
Chapter 6
www.ins.state.ny.us
Concept
Questions
Financial Services: Insurance
157
ways from deposit insurance. First, although these programs are sponsored by
state insurance regulators, they are actually run and administered by the (private)
insurance companies themselves.
Second, unlike DIF, in which the FDIC has established a permanent reserve
fund by requiring banks to pay annual premiums in excess of payouts to resolve
failures (see Chapter 19), no such permanent guarantee fund exists for the insurance industry—with the sole exception of the PC and life guarantee funds in the
state of New York. This means that contributions are paid into the guarantee fund
by surviving firms in a state only after an insurance company has actually failed.
Third, the size of the required contributions that surviving insurers make to
protect policyholders in failed insurance companies differs widely from state to
state. In those states that have guarantee funds, each surviving insurer is normally
levied a pro rata amount, according to the size of its statewide premium income.
This amount either helps pay off small policyholders after the assets of the failed
insurer have been liquidated or acts as a cash injection to make the acquisition of a
failed insurer attractive. The definition of small policyholders varies among states
in the range of holding policies from $100,000 to $500,000.
Finally, because no permanent fund exists and the annual pro rata payments to
meet payouts to failed insurer policyholders are often legally capped, a delay usually occurs before small policyholders receive the cash surrender values of their
policies or other payment obligations from the guarantee fund. This contrasts
with deposit insurance, which normally provides insured depositors immediate
coverage of their claims up to $250,000.
1.
2.
3.
4.
5.
6.
What is the difference between a life insurance contract and an annuity contract?
Describe the different forms of ordinary life insurance.
Why do life insurance companies invest in long-term assets?
What is the major source of life insurance underwriting risk?
Who are the main regulators of the life insurance industry?
Why is traditional life insurance in decline?
PROPERTY–CASUALTY INSURANCE
Property insurance involves insurance coverages related to the loss of real and
personal property. Casualty—or, perhaps more accurately, liability—insurance
concerns protection against legal liability exposures. However, the distinctions
between the two broad areas of property and liability insurance are increasingly
becoming blurred. This is due to the tendency of property–casualty (PC) insurers
to offer multiple-activity line coverages combining features of property and liability insurance into single policy packages, for example, homeowners multiple-peril
insurance.
Size, Structure, and Composition of the Industry
Currently, some 2,700 companies sell property–casualty insurance, with approximately half of these firms writing PC business in all or most of the United States.
The total assets of the PC industry in 2012 were $1.6 trillion, or approximately
30 percent of the life insurance industry’s assets. The U.S. PC insurance industry is
158
Part One
Introduction
quite concentrated. Collectively, the top 10 firms have a 50 percent share of the
overall PC market measured by premiums written, and the top 200 firms made
up 95 percent of the industry premiums written. In 2012, the top firm (State Farm)
wrote 10.5 percent of all PC insurance premiums, while the second-ranked insurer
(Liberty Mutual) wrote 5.3 percent (i.e., a joint total of 15.8 percent of premiums
written). In contrast, in 1985, the top two firms wrote 14.5 percent of the total
industry insurance premiums. Thus, the industry leaders appear to be increasing
their share of this financial service sector. As with banks, much of this consolidation is coming through mergers and acquisitions.
Types of Property–Casualty Insurance
In this section we describe the key features of the main PC lines. Note, however,
that some PC activity lines are marketed as different products to both individuals
and commercial firms (e.g., auto insurance), while other lines are marketed to one
specific group (e.g., boiler and machinery insurance targeted at commercial purchasers). To understand the importance of each line in terms of premium income
and losses incurred, look at Table 6–4. The following data show the changing
TABLE 6–4
Property and
Casualty
Insurance Industry
Underwriting by
Lines, 2011
Source: BestWeek, August
2012.
Net Premiums Written* Losses Incurred†
Fire
$ 13.38
44.6%
Allied lines
11.72
73.3
Farm owners multiple peril (MP)
3.18
87.6
Multiple peril crop
12.36
87.6
Homeowners MP
74.57
76.0
Commercial MP
33.92
62.5
Mortgage guaranty
4.57
194.6
Ocean marine
4.10
42.0
Inland marine
14.09
49.9
Financial guaranty
1.06
136.6
Medical professional liability
10.30
35.5
Earthquake
2.77
9.4
Group accident and health
4.72
62.2
Individual accident and health
3.80
70.6
Workers’ compensation
43.99
70.7
Other liability
46.93
48.4
Products liability
2.88
63.7
Private passenger auto liability
103.73
69.7
Commercial auto liability
18.62
56.9
Private passenger auto physical damage (PD)
65.51
64.7
Commercial auto PD
5.46
68.3
Aircraft
1.80
50.2
Fidelity
1.17
46.0
Surety
5.15
13.2
Burglary and theft
0.22
23.8
Boiler and machinery
1.41
35.9
Credit
2.36
27.3
Warranty
2.81
68.5
Flood
2.80
62.4
Other lines
2.18
47.1
Total
* In billions of dollars.
†
To premiums earned.
$501.56
65.5%
Chapter 6
net premiums
written
The entire amount of
premiums written on
insurance contracts.
Financial Services: Insurance
159
composition in net premiums written (NPW) (the entire amount of premiums on
insurance contracts written) for major PC lines over the 1960–2011 period. Important PC lines include the following:
• Fire insurance and allied lines. Protects against the perils of fire, lightning, and
removal of property damaged in a fire (2.7 percent of all premiums written in
2011; 16.6 percent in 1960).
• Homeowners multiple-peril (MP) insurance. Protects against multiple perils of
damage to a personal dwelling and personal property as well as provides liability coverage against the financial consequences of legal liability due to injury
done to others. Thus, it combines features of both property and liability insurance (14.9 percent of all premiums written in 2011; 5.2 percent in 1960).
• Commercial multiple-peril insurance. Protects commercial firms against perils;
similar to homeowners multiple-peril insurance (6.8 percent of all premiums
written in 2011; 0.4 percent in 1960).
• Automobile liability and physical damage (PD) insurance. Provides protection
against (1) losses resulting from legal liability due to the ownership or use of
the vehicle (auto liability) and (2) theft of or damage to vehicles (auto physical
damage) (38.5 percent of all premiums written in 2011; 43.0 percent in 1960).
• Liability insurance (other than auto). Provides either individuals or commercial
firms with protection against non-automobile-related legal liability. For commercial firms, this includes protection against liabilities relating to their business operations (other than personal injury to employees covered by workers’
compensation insurance) and product liability hazards (12.0 percent of all premiums written in 2011; 6.6 percent in 1960).
Balance Sheet and Recent Trends
The Balance Sheet and Underwriting Risk
unearned
premiums
Reserve set-aside that
contains the portion
of a premium that
has been paid before
insurance coverage
has been provided.
The balance sheet of PC firms at the beginning of 2012 is shown in Table 6–5.
Similar to life insurance companies, PC insurers invest the majority of their assets
in long-term securities, thus subjecting them to credit and interest rate risks. Bonds
($931.1 billion), preferred stock ($11.6 billion), and common stock ($228.8 billion)
constituted 72.0 percent of total assets in 2012. PC insurers hold mainly long-term
securities for two reasons. First, PC insurers, like life insurers, hold long-term
assets to match the maturity of their longer-term contractual liabilities. Second,
PC insurers, unlike life insurers, have more uncertain payouts on their insurance
contracts (i.e., they incur greater levels of liquidity risk). Thus, their asset structure
includes many assets with relatively fixed returns that can be liquidated easily
and at low cost. Looking at their liabilities, we can see the major component is
the loss reserve and loss adjustment expenses ($632.4 billion) set aside to meet
expected losses from underwriting and administrative expenses associated with
the PC lines just described. This item constitutes 38.9 percent of total liabilities
and capital. Unearned premiums (a reserve set-aside that contains the portion of
a premium that has been paid before insurance coverage has been provided) are
also a major liability, representing 15.4 percent of total liabilities and capital.
To understand how and why a loss reserve on the liability side of the balance
sheet is established, we need to understand the risks of underwriting PC insurance. In particular, PC underwriting risk results when the premiums generated
on a given insurance line are insufficient to cover (1) the claims (losses) incurred
160
Part One
Introduction
TABLE 6–5
Balance Sheet
for the Property–
Casualty Industry,
2012 (in billions of
dollars)
Source: Reprinted with
permission from A.M. Best’s
Aggregates and Averages,
property–casualty, 2012, p. 1.
www.ambest.com
Percent of
Total Assets
Assets
Unaffiliated investments
Bonds
Preferred stocks
Common stocks
Real estate investments
Cash and short-term investments
Other invested assets
Net deferred taxes
Reinsurance
Premium balances
Accrued interest
Other assets
$1,374.0
$931.1
11.6
228.8
15.4
76.3
110.8
84.5%
57.2%
0.7
14.1
1.0
4.7
6.8
29.1
43.1
128.7
10.6
41.1
Total assets
1.8
2.6
7.9
0.7
2.5
$1,626.6
100.0%
Loss reserve and loss adjustment expenses
Unearned premiums
Other liabilities
$ 632.4
251.4
168.4
38.9%
15.4
10.4
Total liabilities
Policyholders surplus
Capital and assigned surplus
Surplus notes
Unassigned surplus
$1,052.2
$ 574.4
64.7%
35.3%
Liabilities and Capital/Surplus
Total liabilities and capital/surplus
$248.0
15.2
311.2
15.3%
0.9
19.1
$1,626.6
100.0%
insuring against the peril and (2) the administrative expenses of providing that
insurance (legal expenses, commissions, taxes, etc.) after taking into account (3)
the investment income generated between the time premiums are received and
the time claims are paid. Thus, underwriting risk may result from (1) unexpected
increases in loss rates, (2) unexpected increases in expenses, and/or (3) unexpected decreases in investment yields or returns. Next, we look more carefully at
each of these three areas of PC underwriting risk.
Loss Risk The key feature of claims loss exposure is the actuarial predictability of
losses relative to premiums earned. This predictability depends on a number of
characteristics or features of the perils insured, specifically:
• Property versus liability. In general, the maximum levels of losses are more predictable for property lines than for liability lines. For example, the monetary
value of the loss of, or damage to, an auto is relatively easy to calculate, while
the upper limit to the losses an insurer might be exposed to in a product liability line—for example, asbestos damage to workers’ health under other liability
insurance—may be difficult, if not impossible, to estimate.
• Severity versus frequency. In general, loss rates are more predictable on low severity, high-frequency lines than they are on high-severity, low-frequency lines.
For example, losses in fire, auto, and homeowners peril lines tend to involve
events expected to occur with a high frequency and to be independently distributed across any pool of the insured. Furthermore, the dollar loss on each
event in the insured pool tends to be relatively small. Applying the law of large
Chapter 6
frequency of loss
The probability that a
loss will occur.
severity of loss
The size of the loss.
long-tail loss
A claim that is made
some time after a
policy was written.
Financial Services: Insurance
161
numbers, insurers can estimate the expected loss potential of such lines—the
frequency of loss times the size of the loss (severity of loss)—within quite
small probability bounds. Other lines, such as earthquake, hurricane, and
financial guaranty insurance, tend to insure very low-probability (frequency)
events. Here the probabilities are not always stationary, the individual risks in
the insured pool are not independent, and the severity of the loss could be enormous. This means that estimating expected loss rates (frequency times severity)
is extremely difficult in these coverage areas. For example, even with the new
federal terrorism insurance program introduced in 2002, coverage for highprofile buildings in big cities, as well as other properties considered potential
targets, remains expensive. Under the 2002 federal program, the government
is responsible for 90 percent of insurance industry losses that arise from any
future terrorist incidents that exceed a minimum amount. The government’s
losses are capped at $100 billion per year. Each insurer has a maximum amount
it would pay before federal aid kicks in. In 2012, the amount was 15 percent of
each company’s commercial property–casualty premiums. The result is that in
some cases, the cost of terrorism insurance has been reduced significantly since
the new law took effect. But those buildings viewed as target risks will continue to have much higher premiums than properties outside of major cities.
This higher uncertainty of losses forces PC firms to invest in more short-term
assets and hold a larger percentage of capital and reserves than life insurance
firms hold.
• Long tail versus short tail. Some liability lines suffer from a long-tail risk exposure phenomenon that makes the estimation of expected losses difficult. This
long-tail loss arises in policies in which the insured event occurs during a coverage period but a claim is not filed or reported until many years later. The
delay in filing of a claim is in accordance with the terms of the insurance contract and often occurs because the detrimental consequences of the event are
not known for a period of time after the event actually occurs. Losses incurred
but not reported have caused insurers significant problems in lines such as
medical malpractice and other liability insurance where product damage suits
(e.g., the Dalkon shield case and asbestos cases) have mushroomed many years
after the event occurred and the coverage period expired.3 For example, in
2002 Halliburton, a major U.S. corporation, agreed to pay $4 billion in cash and
stock, and to seek bankruptcy protection for a subsidiary, to settle more than
300,000 asbestos claims. To resolve its growing asbestos liability, Halliburton
considered a novel step that put one of its biggest subsidiaries into bankruptcy
courts, while allowing Halliburton to hold on to the rest of its businesses. Questions still remain about how much insurance companies will be required to
reimburse Halliburton for the cost of asbestos case settlements and when. The
company had only $1.6 billion of expected insurance on its books for asbestos
claims. If Halliburton is successful in putting just one of its subsidiaries (and
not the entire firm) into bankruptcy, it could set a precedent for many companies, such as Honeywell International and Dow Chemical, which were also trying to contain their asbestos risk in subsidiaries.
• Product inflation versus social inflation. Loss rates on all PC property policies are
adversely affected by unexpected increases in inflation. Such increases were
3
In some product liability cases, such as those involving asbestos, the nature of the risk being covered
was not fully understood at the time many of the policies were written.
162
Part One
Introduction
triggered, for example, by the oil price shocks of 1973, 1978, and 2008. However,
in addition to a systematic unexpected inflation risk in each line, there may
be line-specific inflation risks. The inflation risk of property lines is likely to
reflect the approximate underlying inflation risk of the economy. Liability lines
may be subject to social inflation, as reflected in juries’ willingness to award
punitive and other liability damages at rates far above the underlying rate of
inflation. Such social inflation has been particularly prevalent in commercial
liability and medical malpractice insurance and has been directly attributed by
some analysts to faults in the U.S. civil litigation system.
Reinsurance An alternative to managing risk on a PC insurer’s balance sheet is
to purchase reinsurance from a reinsurance company. Reinsurance is essentially
insurance for insurance companies. Note from Table 6–5 that reinsurance (the payments that may be collected under reinsurance contracts) represented 2.6 percent
of total assets in 2012. Reinsurance is a way for primary insurance companies to
protect against unforeseen or extraordinary losses. Depending on the contract, reinsurance can enable the insurer to improve its capital position, expand its business,
limit losses, and stabilize cash flows, among other things. In addition, the reinsurer,
drawing information from many primary insurers, will usually have a far larger
pool of data for assessing risks. Reinsurance takes a variety of forms. It may represent a layer of risk, such as losses within certain limits, say, $5 million to $10 million,
that will be paid by the reinsurer to the primary insurance company for which a
premium is paid, or a sharing of both losses and profits for certain types of business.
Reinsurance is an international business. About 75 percent of the reinsurance business that comes from U.S. insurance companies is written by non-U.S. reinsurers
such as Munich Re. Some investment banks are now setting up reinsurers as part of
a move to develop alternative risk financing deals such as catastrophe bonds.
Insurers and reinsurers also typically issue catastrophe bonds. The bonds pay
high interest rates and diversify an investor’s portfolio because natural disasters
occur randomly and are not associated with (independent of) economic factors.
Depending on how the bond is structured, if losses reach the threshold specified
in the bond offering, the investor may lose all or part of the principal or interest. For example, a deep-discount or zero-coupon catastrophe bond would pay
100(1 ⫺ ␣) on maturity, where ␣ is the loss rate due to the catastrophe. Thus,
Munich Re issued a $250 million catastrophe bond in 2012 where ␣ (the loss rate)
reflected losses incurred on all reinsurer policies over a 24-hour period should an
event (such as a flood or hurricane) occur and losses exceed a certain threshold. The
required yield on these bonds reflected the risk-free rate plus a premium reflecting
investors’ expectations regarding the probability of the event’s occurring.
loss ratio
Ratio that measures
pure losses incurred
to premiums earned.
premiums earned
Premiums received
and earned on
insurance contracts
because time has
passed with no claim
being filed.
Measuring Loss Risk The loss ratio measures the actual losses incurred on a line.
It measures the ratio of losses incurred to premiums earned (premiums received
and earned on insurance contracts because time has passed with no claim being
filed). Thus, a loss ratio less than 100 means that premiums earned were sufficient
to cover losses incurred on that line. Aggregate loss ratios for the period 1951–2012
are shown in Table 6–6. Notice the steady increase in industry loss ratios over the
period, increasing from the 60 percent range in the 1950s to the 70 and 80 percent
range in the 1980s into the 2010s. For example, in 2011, the aggregate loss ratio on
all PC lines was 79.4. This includes, however, loss adjustment expenses (LAE)—
see below—as well as (pure) losses. The (pure) loss ratio, net of LAE, in 2011 was
65.5 (see Table 6–4).
Chapter 6
TABLE 6–6
Industry
Underwriting
Ratios
Source: Best’s Review, various
issues. www.ambest.com
Financial Services: Insurance
163
Year
Loss Ratio*
Expense
Ratio†
Combined
Ratio
Dividends to
Policyholders‡
Combined Ratio
after Dividends
1951
1960
1965
1970
1975
1980
1985
1990
1995
1997
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
60.3
63.8
70.3
70.8
79.3
74.9
88.7
82.3
78.8
72.8
81.4
88.4
81.1
74.7
73.3
74.8
66.2
68.0
77.4
73.2
73.5
79.4
73.9
34.0
32.2
30.4
27.6
27.3
26.5
25.9
26.0
26.2
27.1
27.8
26.9
25.6
24.9
25.0
25.5
25.4
27.1
27.2
27.3
28.4
28.4
29.8
94.3
96.0
100.7
98.4
106.6
101.4
114.6
108.3
105.0
99.9
109.2
115.3
106.7
99.6
98.3
100.3
91.6
95.1
104.6
100.5
101.9
107.8
103.7
2.6
2.2
1.9
1.7
1.3
1.7
1.6
1.2
1.4
1.7
1.3
0.7
0.5
0.5
0.4
0.6
0.8
0.5
0.5
0.5
0.5
0.4
0.3
96.9
98.2
102.6
100.1
107.9
103.1
116.2
109.6
106.4
101.6
110.5
116.0
107.2
100.1
98.7
100.9
92.4
95.6
105.1
101.0
102.4
108.2
104.0
* Losses and adjustment expenses incurred to premiums earned.
†
Expenses incurred (before federal income taxes) to premiums written.
‡
Dividends to policyholders to premiums earned.
combined ratio
Ratio that measures
the overall underwriting profitability of a
line; it is equal to the
loss ratio plus the
ratios of loss adjustment expenses to
premiums earned
and commission and
other acquisition costs
to premiums written
plus any dividends
paid to policyholders as a proportion of
premiums earned.
Expense Risk The two major sources of expense risk to PC insurers are (1) loss
adjustment expenses (LAE) and (2) commissions and other expenses. Loss adjustment expenses relate to the costs surrounding the loss settlement process; for example, many PC insurers employ adjusters who determine the liability of the insurer
and the size of the adjustment or settlement to be made. The other major area of
expense occurs in the commission costs paid to insurance brokers and sales agents
and other expenses related to the acquisition of business. As mentioned above, the
loss ratio reported in Table 6–6 includes LAE. The expense ratio reported in Table 6–6
reflects commissions and other (non-LAE) expenses for PC insurers over the
1951–2012 period. In contrast to the increasing trend in the loss ratio, the expense
ratio generally decreased over the period shown. Expenses can account for significant portions of the overall costs of operations. In 2011, for example, expenses—other
than LAE—amounted to 28.4 percent of premiums written. Clearly, sharp rises in
insurance broker commissions and other operating costs can rapidly render an insurance line unprofitable. One of the reasons for the secular decline in the expense ratio
has been the switch in the way PC insurance has been distributed. Specifically, rather
than relying on independent brokers to sell policies (the American agency method
of distribution), large insurance companies are increasingly selling insurance to the
public directly through their own brokers (the direct writer method of distribution).
A common measure of the overall underwriting profitability of a line, which
includes both loss and expense experience, is the combined ratio. Technically,
the combined ratio is equal to the loss ratio plus the ratios of LAE to premiums
earned, commissions and other acquisition costs and general expense costs to
164
Part One
Introduction
premiums written, plus any dividends paid to policyholders as a proportion of
premiums earned. The combined ratio after dividends adds any dividends paid
to policyholders as a proportion of premiums earned to the combined ratio. If the
combined ratio is less than 100, premiums alone are sufficient to cover both losses
and expenses related to the line.
If premiums are insufficient and the combined ratio exceeds 100, the PC insurer
must rely on investment income earned on premiums for overall profitability. For
example, in 2001 the combined ratio before dividend payments was 116.0, indicating that premiums alone were insufficient to cover the costs of both losses and
expenses related to writing PC insurance. Table 6–6 presents the combined ratio
and its components for the PC industry for the years 1951–2012. We see that, over
this period, premiums have often been unable to cover losses and expenses (i.e.,
combined ratios have generally been greater than 100).
operating ratio
A measure of the
overall profitability of
a PC insurer; it equals
the combined ratio
minus the investment
yield.
Investment Yield/Return Risk As discussed above, when the combined ratio is
more than 100, overall profitability can be ensured only by a sufficient investment
return on premiums earned. That is, PC firms invest premiums in assets between the
time they are received and the time they are paid out to meet claims. For example,
in 2012 net investment income to premiums earned (or the PC insurers’ investment
yield) was 10.5 percent. As a result, the overall average profitability (or operating
ratio) of PC insurers was 93.5. It was equal to the combined ratio after dividends
(104.0) minus the investment yield 10.5. Since the operating ratio was less than 100,
PC insurers were profitable in 2012. However, lower net returns on investments
(e.g., 3.5 percent rather than 10.5 percent) would have meant that underwriting PC
insurance was marginally unprofitable (i.e., the operating ratio of insurers in this
case would have been 100.5). Thus, the effect of interest rates and default rates on PC
insurers’ investments is crucial to PC insurers’ overall profitability. That is, measuring and managing credit and interest rate risk are key concerns of PC managers.
Consider the following example. Suppose an insurance company’s projected
loss ratio is 79.8 percent, its expense ratio is 27.9 percent, and it pays 2 percent
of its premiums earned to policyholders as dividends. The combined ratio (after
dividends) for this insurance company is equal to:
Loss ratio ⫹ Expense ratio ⫹ Dividend ratio ⫽ Combined ratio after dividends
79.8
⫹
27.9
⫹
2.0
⫽
109.7
Thus, expected losses on all PC lines, expenses, and dividends exceeded premiums earned by 9.7 percent.
If the company’s investment portfolio, however, yielded 12 percent, the operating ratio and overall profitability of the PC insurer would be:
Operating ratio ⫽ Combined ratio after dividends ⫺ Investment yield
⫽
⫽
109.7
97.7 percent
⫺
and
Overall profitability ⫽ 100 ⫺ Operating ratio
⫽ 100 ⫺ 97.7
⫽ 2.3 percent
12.0
Chapter 6
Financial Services: Insurance
165
As can be seen, the high investment returns (12 percent) make the PC insurer profitable overall.
Given the importance of investment returns to PC insurers’ profitability, we can
see from the balance sheet in Table 6–5 that bonds—both Treasury and corporate—
dominated the asset portfolios of PC insurers. Bonds constituted 57.2 percent of
total assets and 67.8 percent of financial assets (so-called unaffiliated investments)
in 2012.
Finally, if losses, expenses, and other costs are higher and investment yields
are lower than expected so that operating losses are incurred, PC insurers carry
a significant amount of surplus reserves (policyholder surplus) to reduce the risk
of insolvency. In 2012, the ratio of policyholder surplus to assets was 35.3 percent.
Recent Trends
underwriting cycle
The tendency of profits in the PC industry
to follow a cyclical
pattern.
www.iso.com
While catastrophes should be random, the period 1985–2012 was characterized
by a number of catastrophes of historically high severity, as shown in Figure 6–3.
In the terminology of PC insurers, the industry experienced troughs of an underwriting cycle, or underwriting conditions were hard. These cycles are characterized by periods of rising premiums leading to increased profitability. Following
a period of solid but not spectacular rates of returns, the industry enters a down
phase in which premiums soften as the supply of insurance products increases. As
a result, most of the period 1985–2012 was not very profitable for the PC industry.
In particular, the combined ratio (the measure of loss plus expense risk) was 116.2
in 1987, 115.7 in 1992, and 116.0 in 2001. (Remember that a combined ratio higher
than 100 is bad in that it means that losses, expenses, and dividends totaled more
than premiums earned.) The major reason for these losses was a succession of
catastrophes from Hurricane Hugo in 1989, the San Francisco earthquake in 1991,
the Oakland fires of 1991, and the almost $20 billion in losses incurred in Florida
as a result of Hurricane Andrew in 1991.
In 1993 the industry showed signs of improvement, with the combined ratio falling to 106.9. However, in 1994 that ratio rose again to 108.4, partly as a result of the
Northridge earthquake with estimated losses of $7 billion to $10 billion. The industry ratio fell back down to 101.6 in 1997. However, major losses associated with El
Niño (e.g., Hurricane Georges and Midwest storms) drove the combined ratio back
up to 105.6 in 1998. The combined ratio increased even further to 107.9 in 1999 and
110.5 in 2000. Part of these increases is attributable to an increase in amounts paid
on asbestos claims. In 1999, $3.4 billion was paid out on these claims, the largest
payouts ever. The Insurance Services Office Inc. estimates that the combined ratio
for 1999, 107.9, would have been one percentage point lower without these claims.
The year 2001 saw yet another blow to the insurance industry and the world
with the terrorist attacks on the World Trade Center and the Pentagon. Early
estimates of the costs of these attacks to insurance companies were as high as
$40 billion. It was estimated that only 10 percent of the September 11 losses were
reported in 2001, and yet the losses attributed to the terrorist attacks added an estimated 4 percentage points to the combined ratio after dividends of 116.0. Because
of the tremendous impact these attacks had on the health of the U.S. insurance
industry, the Bush administration proposed that the U.S. government pay the
majority of the losses of the insurance industry due to the attacks. The proposal
capped insurers’ 2002 liabilities at $12 billion, 2003 liabilities at $23 billion, and
2004 liabilities at $36 billion. Despite this bailout of the industry, many insurers
did not survive and those that did were forced to increase premiums significantly.
166
Part One
Introduction
FIGURE 6–3 U.S. Catastrophes, 1949–2012
Sources: Richard L. Sandor, Center Financial Products, 1949–1994; authors’ research,1995–2012.
$50
$45
$66,000
2001
2012
2004
1992
2012
2011
2008
2005
1994
2005
1989
2003
1998
1965
1995
1996
1992
1993
1999
40,000
25,000
25,000
19,900
16,000
14,200
12,500
10,300
7,200
5,627
4,939
3,100
2,900
2,346
2,100
2,000
1,646
1,625
1,600
Catastrophe
Year
Hurricane Fran
Hurricane Frederic
Wind, hail, tornadoes
Minnesota storms
Freeze
Oakland fire
Hurricane Cecelia
Wind
California earthquake
Midwest drought
Texas hailstorm
Midwest storms
Hurricane Isabel
Hurricane Alicia
L.A. riots
1995
1979
1974
1998
1983
1991
1970
1950
1989
2000
1995
1998
2003
1983
1992
$1,600
1,575
1,395
1,300
1,280
1,273
1,169
1,136
1,130
1,100
1,100
1,000
1,000
983
797
Terrorists attacks on WTC
$40
Amount ($ millions)
$35
$30
Hurricane Sandy
$55
2005
Hurricane Katrina
$60
Year
Hurricane Katrina
Terrorist attacks on WTC
and Pentagon
Hurricane Sandy
Florida Hurricanes
Hurricane Andrew
Midwest drought
Midwest tornadoes
Hurricane Ike
Hurricane Wilma
Northridge earthquake
Hurricane Rita
Hurricane Hugo
Midwest tornadoes
Hurricane Georges
Hurricane Betsy
Hurricane Opal
Blizzard of 1996
Hurricane Iniki
Blizzard of 1993
Hurricane Floyd
Florida hurricanes
$65
Amount ($ millions)
Catastrophe
and Pentagon
$70
$0
Hurricane Ike
Hurricane Wilma
Hurricane Rita
Midwest tornadoes
Hurricane Isabel
Minnesota storms
Hurricane Georges
Midwest storms
Hurricane Floyd
Midwest drought
Northridge earthquake
Texas hailstorm
Hurricane Opal
Hurricane Fran
Blizzard
Hurricane Iniki
Blizzard
Oakland fires
L.A. riots
Hurricane Hugo
California earthquake
Hurricane Alicia
Freeze
Hurricane Frederic
Wind
$5
Tornadoes
Hurricane Betsy
$10
Hurricane Cecelia
$15
Hurricane Andrew
$20
Midwest tornadoes
Midwest drought
$25
1949 1956 1961 1966 1969 1973 1975 1977 1979 1980 1982 1984 1986 1988 1989 1991 1992 1994 1995 1996 1998 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Year
Chapter 6
Financial Services: Insurance
167
After several tumultuous years, 2003 saw profitability in the PC industry
improve. The combined ratio after dividends was 100.1, down sharply from
107.2 in 2002, and much better than most analysts and industry experts expected.
The 2003 results were the best since 1979, when the combined ratio was 100.6. In
2004, Florida and the East coast were hit with several major hurricanes including
Hurricanes Charley, Frances, Ivan, and Jeanne (the estimated losses from these four
hurricanes were $25 billion). Yet, these were the only major catastrophes to occur
in 2004. As a result, the industry saw its first overall profitable year since the 1960s.
The combined ratio in 2004 was 98.7. In 2005 the PC industry reported a combined
ratio of 100.9. The losses resulted from $57.7 billion in catastrophe losses primarily
resulting from the record-breaking hurricane season, which included losses from
Hurricanes Katrina, Wilma, and Rita. These losses added an estimated 8 points to
the industry’s combined ratio. If catastrophe losses are excluded, the combined
ratios for 2005 and 2004 would have been 92.9 and 94.5, respectively. Losses from
the record 2005 hurricane season prompted both Allstate and State Farm to stop
writing new homeowner policies and drop some existing customers altogether. In
2006 and 2007 a small level of catastrophic losses, combined with a strong performance in virtually all other major lines of PC insurance, resulted in combined
ratios of 92.4 (the best underwriting performance since 1936) and 95.6, respectively.
Losses rose significantly in 2008 through 2012 due to jumps in catastrophe losses
(including $12.5 billion from Hurricane Ike, $25.0 billion from Hurricane Sandy, and
$14.2 billion from the Midwest tornadoes) and losses in the mortgage and financial
guarantee segments associated with the financial crisis. Note from Table 6–4 that these
two segments experienced losses of 194.6 and 136.6 percent of premiums written,
respectively, in 2012, down from 214.6 and 416.9 percent of premiums written, respectively, in 2008 at the height of the financial crisis. These losses pushed the 2008 combined ratio to 105.1 (up 9.5 points from 2007). Excluding losses from these two sectors,
the industry’s combined ratio would have been 101.0 for the year. Significantly, lower
catastrophe losses and a recovering economy resulted in an industry combined ratio
of 101.0 in 2009 and 102.4 in 2010. While 2009 saw the third straight year of negative premium growth (the first since the Great Depression), premiums written in 2010
began to recover. Further, few major catastrophes occurred during these two years. As
a result, the combined ratio in 2009 and 2010 fell to 101.0 and 102.4, respectively.
The United States experienced one of the worst years ever in terms of catastrophes in 2011. Insured catastrophe losses totaled $33.6 billion, the fifth most expensive year on record for insured catastrophe losses on an inflation-adjusted basis.
Overall net income after taxes fell 46 percent to $19.2 billion from $35.2 billion
in 2010. Such high catastrophe losses, along with high underwriting losses in
key non-catastrophe-exposed lines such as workers’ compensation, pushed the
industry’s combined ratio to 108.2 (its highest level since 2001). As a result of large
decreases in catastrophe losses and a marked acceleration in premium growth,
profitability in the PC insurance industry rebounded sharply during the first nine
months of 2012. Catastrophe losses fell to $16.2 billion in the first nine months
of 2012 from $32.8 billion in the first nine months of 2011. However, catastrophe
losses from Hurricane Sandy, which made landfall in the northeast United States
in late October, totaled $25.0 billion. As a result, the industry’s combined ratio fell
to 100.9 in the first nine months, to 104.0 for the full year.
The federal government has gradually increased the role of providing compensation and reconstruction assistance following a variety of natural disasters such
as the terrorist attacks of 9/11. Although the insurance industry has been stressed
168
Part One
Introduction
by major catastrophes, it has argued that government involvement in the market
for catastrophe insurance should be minimized to avoid crowding out more efficient private market solutions, such as catastrophe bonds.
Regulation
www.naic.org
Concept
Questions
As with life insurance companies, PC insurers are chartered by states and regulated by state commissions. In addition, state guaranty funds provide some protection to policyholders if an insurance company fails. The National Association
of Insurance Commissioners (NAIC) also provides various services to state regulatory commissions. These services include a standardized examination system
called IRIS (Insurance Regulatory Information System) to identify insurers with
loss, combined, and other ratios outside the normal ranges.
An additional burden that PC insurers face in some activity lines—especially
auto insurance and workers’ compensation insurance—is rate regulation. That is,
given the public utility nature of some insurance lines, state commissioners set
ceilings on premiums and premium increases, usually based on specific cost of
capital and line risk exposure formulas for the insurance suppliers. This had led
some insurers to leave states such as New Jersey, Florida, and California, which
have the most restrictive regulations.
Further, the industry came under attack for the way it handled homeowners’ claims
associated with Hurricane Katrina. Homeowners policies excluded damage caused
by flooding. Insurers insisted the storm surge from Hurricane Katrina was classified
as a flood and that damage therefore was excluded from coverage under policy forms
that had been reviewed by regulators in each state and in force for years. Lawyers for
policyholders of State Farm Insurance Company claimed that insurers were trying
to avoid paying out on their homeowners policies by claiming the cause was a flood
when it was a combination of hurricane winds and a storm surge. They claimed that
the storm surge was not a flood but a direct result of the hurricane’s winds, which is
a covered risk. Policyholders claimed that State Farm and other insurance companies
used “deceptive” sales practices to sell those hurricane policies and collected extra
premiums from them. A verdict in January 2007 not only held State Farm responsible
for policy limits that totaled more than $220,000 on each loss deemed to be due to
storm-surge flooding but also held the company liable for punitive damages.
1.
2.
3.
4.
5.
6.
Why do PC insurers hold more capital and reserves than do life insurers?
Why are life insurers’ assets, on average, longer in maturity than those of PC insurers?
Describe the main lines of insurance offered by PC insurers.
What are the components of the combined ratio?
How does the operating ratio differ from the combined ratio?
Why does the combined ratio tend to behave cyclically?
GLOBAL ISSUES
£ ¥
:$
Like the other sectors of the financial institutions industry, the insurance sector
is becoming increasingly global. Table 6–7 lists the top 10 countries in terms of
total premiums written in 2011 (in U.S. dollars) and their percentage share of the
world market. Table 6–8 lists the top 10 insurance companies worldwide by total
Chapter 6
TABLE 6–7
Financial Services: Insurance
169
The World’s Top Countries in Terms of Insurance Premiums Written
Source: Swiss Re, sigma No 3/2012.
Rank
Country
Life Premiums
Written
(US$ billions)
1
2
3
4
5
6
7
8
9
10
United States
Japan
United Kingdom
France
Germany
China
Italy
South Korea
Canada
Netherlands
$537.6
524.7
210.1
174.8
113.9
134.5
105.1
79.2
52.2
31.2
Property–Casualty
Premiums Written
(US$ billions)
Total Premiums
Written
(US$ billions)
Share of
World Market
$667.1
103.7
109.5
98.3
131.3
87.3
55.4
51.2
69.0
79.7
$1,204.7
655.4
319.6
273.1
245.2
221.8
160.5
130.4
121.2
110.9
26.2%
14.3
7.0
5.9
5.3
4.8
3.5
2.8
2.6
2.4
TABLE 6–8
World’s Largest
Insurance
Companies by Total
Revenues
Source: Insurance Information Institute website, 2012.
www.iii.org
Rank
Company
Revenues
(US$ billions)
Home Country
$211.0
142.7
112.6
90.8
77.5
70.6
67.3
62.5
61.8
58.5
Japan
France
Italy
Japan
Japan
United States
China
Japan
United Kingdom
United Kingdom
$143.7
134.2
90.1
71.7
64.3
53.0
47.7
43.3
36.5
35.3
United States
Germany
Germany
United States
United States
Switzerland
Japan
Japan
China
Japan
Panel A: Life Insurers
1
2
3
4
5
6
7
8
9
10
Japan Post Holdings
AXA Group
Assicurazioni Generali
Nippon Life Insurance
Meiji Yasuda Life
MetLife
China Life Insurance
Dai-ichi Mutual Life
Aviva
Prudential
Panel B: Property–Casualty Insurers
1
2
3
4
5
6
7
8
9
10
Berkshire Hathaway
Allianz
Munich Re Group
American International Group
State Farm Insurance
Zurich Financial Services
MS&AD Insurance Group
Tokio Marine
People’s Insurance Co. of China
NKSJ Holdings
revenues. While the United States, Japan, and western Europe dominate the global
market, all regions are engaged in the insurance business and many insurers are
engaged internationally.
Worldwide, 2011 was a bad year for life and PC insurers. Catastrophe losses
were the worst on record. Japan’s earthquake and tsunami (with insured losses
of $40 billion), earthquakes in New Zealand (with insured losses of $13 billion),
170
Part One
Introduction
www.mhhe.com/saunders8e
floods in Thailand (insured losses of $10 billion), and a series of severe tornadoes
in the United States ($14.2 billion) all contributed to $350 billion in disaster losses.
Insurance losses from these disasters would have been far greater had the central
governments in these countries not picked up a large portion of the loss coverage. Worldwide insured losses in 2012 were 36 percent higher than the 10-year
average ($72 billion versus $53 billion), mainly due to events in the United States
(discussed above). However, except for the earthquake in Italy (with insured
losses topping $1.6 billion), no major catastrophes occurred outside the United
States. Insured losses in Europe, Asia, and Canada were far below their 10-year
averages.
Summary
This chapter examined the activities and regulation of insurance companies. The
first part of the chapter described the various classes of life insurance and recent
trends. The second part covered property–casualty companies. The various lines
that make up property–casualty insurance are becoming increasingly blurred as
multiple-activity line coverages are offered. Both life and property–casualty insurance companies are regulated at the state rather than the federal level. In addition,
both are coming under threat from other financial service firms that offer similar
or competitive products.
Questions
and Problems
1. What is the primary function of an insurance company? How does this function compare with the primary function of a depository institution?
2. What is the adverse selection problem? How does adverse selection affect the
profitable management of an insurance company?
3. What are the similarities and differences among the four basic lines of life insurance products?
4. Explain how annuity activities represent the reverse of life insurance activities.
5. Explain how life insurance and annuity products can be used to create a steady
stream of cash disbursements and payments to avoid paying or receiving a single lump-sum cash amount.
6. a. Calculate the annual cash flows from a $1 million, 20-year fixed-payment
annuity earning a guaranteed 10 percent per year if payments are to begin at
the end of the current year.
b. Calculate the annual cash flows from a $1 million, 20-year fixed-payment
annuity earning a guaranteed 10 percent per year if payments are to begin at
the end of year 5.
c. What is the amount of the annuity purchase required if you wish to receive
a fixed payment of $200,000 for 20 years? Assume that the annuity will earn
10 percent per year.
7. You deposit $10,000 annually into a life insurance fund for the next 10 years,
after which time you plan to retire.
a. If the deposits are made at the beginning of the year and earn an interest rate
of 8 percent, what will be the amount of retirement funds at the end of year 10?
b. Instead of a lump sum, you wish to receive annuities for the next 20 years
(years 11 through 30). What is the constant annual payment you expect to
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
Financial Services: Insurance
171
receive at the beginning of each year if you assume an interest rate of
8 percent during the distribution period?
c. Repeat parts (a) and (b) above assuming earning rates of 7 percent and
9 percent during the deposit period and earning rates of 7 percent and
9 percent during the distribution period. During which period does the
change in the earning rate have the greatest impact?
You deposit $12,000 annually into a life insurance fund for the next 10 years,
at which time you plan to retire. Instead of a lump sum, you wish to receive
annuities for the next 20 years. What is the annual payment you expect to
receive beginning in year 11 if you assume an interest rate of 6 percent for the
whole time period?
a. Suppose a 65-year-old person wants to purchase an annuity from an insurance company that would pay $20,000 per year until the end of that person’s life. The insurance company expects this person to live for 15 more
years and would be willing to pay 6 percent on the annuity. How much
should the insurance company ask this person to pay for the annuity?
b. A second 65-year-old person wants the same $20,000 annuity, but this
person is much healthier and is expected to live for 20 years. If the same
6 percent interest rate applies, how much should this healthier person be
charged for the annuity?
c. In each case, what is the difference in the purchase price of the annuity if
the distribution payments are made at the beginning of the year?
Contrast the balance sheet of a life insurance company (Table 6–3) with the
balance sheet of a commercial bank (Table 2–6) and with that of a savings
institution (Table 2–10). Explain the balance sheet differences in terms of the
differences in the primary functions of the three organizations.
Using the data in Table 6–2, how has the composition of assets of U.S. life
insurance companies changed over time?
How do life insurance companies earn a profit?
How would the balance sheet of a life insurance company change if it offered
to run a private pension fund for another company?
How does the regulation of insurance companies differ from the regulation of
depository institutions? What are the major pieces of life insurance regulatory
legislation?
How do state guarantee funds for life insurance companies compare with
deposit insurance for depository institutions?
What are the two major activity lines of property–casualty insurance firms?
How have the product lines of property–casualty insurance companies changed
over time?
Contrast the balance sheet of a property–casualty insurance company
(Table 6–5) with the balance sheet of a commercial bank (Table 2–6). Explain
the balance sheet differences in terms of the differences in the primary functions of the two organizations.
What are the three sources of underwriting risk in the property–casualty insurance industry?
How do unexpected increases in inflation affect property–casualty insurers?
Identify the four characteristics or features of the perils insured against by
property–casualty insurance. Rank the features in terms of actuarial predictability and total loss potential.
Insurance companies will charge a higher premium for which of the insurance
lines listed below? Why?
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Chapter 6
172
Part One
Introduction
23.
24.
25.
26.
27.
28.
29.
30.
www.mhhe.com/saunders8e
31.
a. Low-severity, high-frequency lines versus high-severity, low-frequency lines.
b. Long-tail lines versus short-tail lines.
What does the loss ratio measure? What has been the long-term trend of the
loss ratio? Why?
What does the expense ratio measure? Identify and explain the two major
sources of expense risk to a property–casualty insurer. Why has the long-term
trend in this ratio been decreasing?
How is the combined ratio defined? What does it measure?
What is the investment yield on premiums earned? Why has this ratio become
so important to property–casualty insurers?
Consider the data in Table 6–6. Since 1980, what has been the necessary investment yield for the industry to enable the operating ratio to be less than 100 in
each year? How is this requirement related to the interest rate risk and credit
risk faced by a property–casualty insurer?
a. What is the combined ratio for a property insurer that has a loss ratio of
73 percent, a loss adjustment expense of 12.5 percent, and a ratio of commissions and other acquisition expenses of 18 percent?
b. What is the combined ratio adjusted for investment yield if the company
earns an investment yield of 8 percent?
An insurance company’s projected loss ratio is 77.5 percent and its loss adjustment expense ratio is 12.9 percent. The company estimates that commission
payments and dividends to policyholders will be 16 percent. What must be
the minimum yield on investments to achieve a positive operating ratio?
An insurance company collected $3.6 million in premiums and disbursed
$1.96 million in losses. Loss adjustment expenses amounted to 6.6 percent and
dividends paid to policyholders totaled 1.2 percent. The total income generated from the company’s investments was $170,000 after all expenses were
paid. What is the net profitability in dollars?
A property-casualty insurer brings in $6.25 million in premiums on its homeowners’ multiple peril line of insurance. The line’s losses amount to $4,343,750,
expenses are $1,593,750, and dividends are $156,250. The insurer earns $218,750
on the investment of its premiums. Calculate the line’s loss ratio, expense ratio,
dividend ratio, combined ratio, investment ratio, operating ratio, and overall
profitability.
Web Questions
32. Go to the Federal Reserve Board’s website at www.federalreserve.gov and
find the most recent distribution of life insurance industry assets for Table 6–2.
Click on “Economic Research and Data.” Click on “Flow of Fund Accounts of
the United States.” Click on the most recent date. Click on “Level tables.” This
will bring the file (Table L.115) onto your computer that contains the relevant
data. How have the values of government securities, corporate securities,
mortgages, and policy loans changed since 2012?
33. Go to the Insurance Information Institute’s website at www.iii.org and use the
following steps to find the most recent data on the largest life insurance companies by total revenue. Click on “Facts & Statistics.” Click on “Life Insurance.”
This will bring the file onto your computer that contains the relevant data.
What are total revenues and assets of the top 10 life insurance companies?
Chapter Seven
Risks of Financial
Institutions
INTRODUCTION
A major objective of FI management is to increase the FI’s returns for its owners.
This often comes, however, at the cost of increased risk. This chapter overviews
the various risks facing FIs: interest rate risk, credit risk, liquidity risk, foreign
exchange risk, country or sovereign risk, market risk, off-balance-sheet risk, technology and operational risk, and insolvency risk. Table 7–1 presents a brief definition of each of these risks. By the end of this chapter, you will have a basic
understanding of the variety and complexity of the risks facing managers of modern FIs. In the remaining chapters of the text, we look at the measurement and
management of the most important of these risks in more detail. As will become
TABLE 7–1
Risks Faced
by Financial
Intermediaries
Interest rate risk The risk incurred by an FI when the maturities of its assets and liabilities
are mismatched.
Credit risk The risk that promised cash flows from loans and securities held by FIs may
not be paid in full.
Liquidity risk The risk that a sudden surge in liability withdrawals may require an FI to
liquidate assets in a very short period of time and at less than fair market prices.
Foreign exchange risk The risk that exchange rate changes can affect the value of an
FI’s assets and liabilities denominated in nondomestic currencies.
Country or sovereign risk The risk that repayments from foreign borrowers may
be interrupted because of restrictions, intervention, or interference from foreign
governments.
Market risk The risk incurred from assets and liabilities in an FI’s trading book due to
changes in interest rates, exchange rates, and other prices.
Off-balance-sheet risk The risk incurred by an FI as the result of activities related to its
contingent assets and liabilities held off the balance sheet.
Technology risk The risk incurred by an FI when its technological investments do not
produce anticipated cost savings.
Operational risk The risk that existing technology, auditing, monitoring, and other
support systems may malfunction or break down.
Insolvency risk The risk that an FI may not have enough capital to offset a sudden
decline in the value of its assets.
173
174
Part One
Introduction
clear, the effective management of these risks is central to an FIs performance.
Indeed, it can be argued that the main business of FIs is to manage these risks.1
While over the past decade, U.S. financial institution profitability has generally
been robust, the risks of financial intermediation have increased as the U.S. and
overseas economies have become more integrated. For example, weakening economic conditions inside and outside the United States—especially in Greece, Italy,
Spain, and Portugal—have presented great risks for those FIs that operate in and
lend to foreign markets and customers. Even those FIs that do not have foreign
customers can be exposed to foreign exchange and sovereign risk if their domestic
customers have business dealings with foreign countries. As a result, FI managers
must devote significant time to understanding and managing the various risks to
which their FIs are exposed.
INTEREST RATE RISK
interest rate risk
The risk incurred
by an FI when the
maturities of its assets
and liabilities are
mismatched.
EXAMPLE 7–1
Impact of an
Interest Rate
Increase on an
FI’s Profits When
the Maturity
of Its Assets
Exceeds the
Maturity of Its
Liabilities
Chapter 1 discussed asset transformation as a key special function of FIs. Asset
transformation involves an FI’s buying primary securities or assets and issuing
secondary securities or liabilities to fund asset purchases. The primary securities
purchased by FIs often have maturity and liquidity characteristics different from
those of the secondary securities FIs sell. In mismatching the maturities of assets
and liabilities as part of their asset-transformation function, FIs potentially expose
themselves to interest rate risk.
Consider an FI that issues $100 million of liabilities of one-year maturity to finance the purchase of $100 million of assets with a two-year maturity. We show this situation in the following time lines:
0
0
Liabilities
($100 million)
1
1
Assets
($100 million)
2
In these time lines the FI can be viewed as being “short-funded.” That is, the maturity of its
liabilities is less than the maturity of its assets.
Suppose the cost of funds (liabilities) for the FI is 9 percent per year and the return on
assets is 10 percent per year. Over the first year the FI can lock in a profit spread of 1 percent
(10 percent ⫺ 9 percent) times $100 million by borrowing short term (for one year) and lending long term (for two years). Thus, its profit is $1 million (0.01 ⫻ $100 m).
However, its profits for the second year are uncertain. If the level of interest rates does not
change, the FI can refinance its liabilities at 9 percent and lock in a 1 percent, or $1 million,
profit for the second year as well. There is always a risk, however, that interest rates will
change between years 1 and 2. If interest rates were to rise and the FI can borrow new
one-year liabilities only at 11 percent in the second year, its profit spread in the second year
1
Recall that Appendix 2B at the book’s website (www.mhhe.com/saunders8e) contains an overview of the
evaluation of FI performance and risk exposure (“Commercial Banks’ Financial Statements and Analysis”).
Included are several accounting ratio–based measures of risk.
Chapter 7
refinancing risk
The risk that the cost
of rolling over or
reborrowing funds
will rise above the
returns being earned
on asset investments.
EXAMPLE 7–2
Impact of an
Interest Rate
Decrease When
the Maturity of
an FI’s Liabilities
Exceeds the
Maturity of Its
Assets
reinvestment risk
175
would actually be negative; that is, 10 percent ⫺ 11 percent ⫽ ⫺1 percent, or the FI’s loss is
$1 million (⫺0.01 ⫻ $100 m). The positive spread earned in the first year by the FI from holding assets with a longer maturity than its liabilities would be offset by a negative spread in
the second year. Note that if interest rates were to rise by more than 1 percent in the second
year, the FI would stand to take losses over the two-year period as a whole. As a result, when
an FI holds longer-term assets relative to liabilities, it potentially exposes itself to refinancing
risk. This is the risk that the cost of rolling over or reborrowing funds could be more than the
return earned on asset investments. The classic example of this type of mismatch was demonstrated by U.S. savings institutions during the 1980s (see Chapter 2).
An alternative balance sheet structure would have the FI borrowing $100 million for a longer
term than the $100 million of assets in which it invests. In the time lines below the FI is “longfunded.” The maturity of its liabilities is longer than the maturity of its assets. Using a similar
example, suppose the FI borrows funds at 9 percent per year for two years and invests the
funds in assets that yield 10 percent for one year. This situation is shown as follows:
1
Liabilities
($100 million)
0
0
The risk that the
return on funds to
be reinvested will
fall below the cost
of funds.
Risks of Financial Institutions
Assets
($100 million)
2
1
In this case, the FI is also exposed to an interest rate risk; by holding shorter-term assets
relative to liabilities, it faces uncertainty about the interest rate at which it can reinvest funds
in the second period. As before, the FI locks in a one-year profit spread of 1 percent, or
$1 million. At the end of the first year, the assets mature and the funds that have been
borrowed for two years have to be reinvested. Suppose interest rates fall between the first
and second years so that in the second year the return on $100 million invested in new
one-year assets is 8 percent. The FI would face a loss, or negative spread, in the second year
of 1 percent (that is, 8 percent asset return minus 9 percent cost of funds), or the FI loses
$1 million (⫺0.01 ⫻ $100 m). The positive spread earned in the first year by the FI from
holding assets with a shorter maturity than its liabilities is offset by a negative spread in the
second year. Thus, the FI is exposed to reinvestment risk; by holding shorter-term assets
relative to liabilities, it faces uncertainty about the interest rate at which it can reinvest funds
borrowed for a longer period. As interest rates fell in the 2000s, good examples of this exposure were provided by banks that borrowed fixed-rate deposits while investing in floatingrate loans, that is, loans whose interest rates changed or adjusted frequently.
In addition to a potential refinancing or reinvestment risk that occurs when
interest rates change, an FI faces market value risk as well. Remember that the market (or fair) value of an asset or liability is conceptually equal to the present value
of current and future cash flows from that asset or liability. Therefore, rising interest rates increase the discount rate on those cash flows and reduce the market
value of that asset or liability. Conversely, falling interest rates increase the market values of assets and liabilities. Moreover, mismatching maturities by holding
longer-term assets than liabilities means that when interest rates rise, the market
176
Part One
Introduction
value of the FI’s assets falls by a greater amount than its liabilities. This exposes
the FI to the risk of economic loss and, potentially, the risk of insolvency.
If holding assets and liabilities with mismatched maturities exposes FIs to reinvestment (or refinancing) and market value risks, FIs can seek to hedge, or protect
against, interest rate risk by matching the maturity of their assets and liabilities.2
This has resulted in the general philosophy that matching maturities is somehow
the best policy to hedge interest rate risk for FIs that are averse to risk. Note, however, that matching maturities is not necessarily consistent with an active assettransformation function for FIs. That is, FIs cannot be asset transformers (e.g.,
transforming short-term deposits into long-term loans) and direct balance sheet
matchers or hedgers at the same time. While reducing exposure to interest rate
risk, matching maturities may also reduce the FI’s profitability because returns
from acting as specialized risk-bearing asset transformers are reduced. As a result,
some FIs emphasize asset–liability maturity mismatching more than others. For
example, depository institutions traditionally hold longer-term assets than liabilities, whereas life insurers tend to match the long-term nature of their liabilities
with long-term assets. Finally, matching maturities hedges interest rate risk only
in a very approximate rather than complete fashion. The reasons for this are technical, relating to the difference between the average life (or duration) and maturity of an asset or liability and whether the FI partly funds its assets with equity
capital as well as liabilities. In the preceding simple examples, the FI financed its
assets completely with borrowed funds. In the real world, FIs use a mix of liabilities and stockholders’ equity to finance asset purchases. When assets and liabilities
are not equal, hedging risk (i.e., insulating FI’s stockholders’ equity values) may
be achieved by not exactly matching the maturities (or average lives) of assets and
liabilities. We discuss the causes of interest rate risk and methods used to measure
interest rate risk in detail in Chapters 8 and 9. We discuss the methods and instruments used to hedge interest rate risk in Chapters 22 through 24.
Concept
Questions
1. What is refinancing risk?
2. Why does a rise in the level of interest rates adversely affect the market value of both
assets and liabilities?
3. Explain the concept of maturity matching.
CREDIT RISK
credit risk
The risk that the
promised cash flows
from loans and securities held by FIs may
not be paid in full.
Credit risk arises because of the possibility that promised cash flows on financial
claims held by FIs, such as loans or bonds, will not be paid in full. Virtually all types
of FIs face this risk. However, in general, FIs that make loans or buy bonds with
long maturities are more exposed than are FIs that make loans or buy bonds
with short maturities. This means, for example, that depository institutions and life
2
This assumes that FIs can directly “control” the maturities of their assets and liabilities. As interest
rates fall, many mortgage borrowers seek to “prepay” their existing loans and refinance at a lower rate.
This prepayment risk—which is directly related to interest rate movements—can be viewed as a further
interest rate–related risk. Prepayment risk is discussed in detail in Chapter 26.
Chapter 7
Risks of Financial Institutions
177
insurers are more exposed to credit risk than are money market mutual funds and
property–casualty insurers. If the principal on all financial claims held by FIs was
paid in full on maturity and interest payments were made on the promised dates,
FIs would always receive back the original principal lent plus an interest return.
That is, they would face no credit risk. If a borrower defaults, however, both the
principal loaned and the interest payments expected to be received are at risk. As
a result, many financial claims issued by corporations and held by FIs promise a
limited or fixed upside return (principal and interest payments to the lender) with
a high probability and a large downside risk (loss of loan principal and promised
interest) with a much smaller probability. Good examples of financial claims issued
with these return-risk trade-offs are fixed-income coupon bonds issued by corporations and bank loans. In both cases, an FI holding these claims as assets earns the
coupon on the bond or the interest promised on the loan if no borrower default
occurs. In the event of default, however, the FI earns zero interest on the asset and
may lose all or part of the principal lent, depending on its ability to lay claim to
some of the borrower’s assets through legal bankruptcy and insolvency proceedings. Accordingly, a key role of FIs involves screening and monitoring loan applicants to ensure that FIs fund the most creditworthy loans (see Chapter 10).
The effects of credit risk are evident in Figure 7–1, which shows commercial
bank charge-off (or write-off) rates for various types of loans between 1984 and
2012. Notice, in particular, the high rate of charge-offs experienced on credit card
loans throughout this period. Indeed, credit card charge-offs by commercial banks
increased persistently from the mid-1980s until 1993 and again from 1995 through
early 1998. By 1998, charge-offs leveled off, and they even declined after 1998.
FIGURE 7–1
Charge-Off Rates for Commercial Bank Lending Activities, 1984–2012
Source: FDIC, Quarterly Banking Profile, various issues. www.fdic.gov
Net charge-off rate (%)
14.0
13.0
12.0
11.0
10.0
9.0
C&I loans
Real estate loans
Credit card loans
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
178
Part One
Introduction
firm-specific credit
risk
The risk of default of
the borrowing firm
associated with the
specific types of project risk taken by that
firm.
systematic credit
risk
The risk of default
associated with general economywide
or macro conditions affecting all
borrowers.
Concept
Questions
However, a weak economy and change in bankruptcy laws3 resulted in a surge in
credit card charge-offs in the early 2000s and during the recession from 2007–2010.
Despite these losses, credit card loans extended by commercial banks (including
unused balances) continued to grow, from $1.856 trillion in March 1997 to $4.367
trillion in September 2008. With the financial crisis, total credit card loans had
fallen to $3.626 trillion in March 2009, and they remained relatively low for several
years as the U.S. economy failed to show any robust growth. In March 2012, credit
card loans extended by commercial banks totaled $3.289 trillion.
The potential loss an FI can experience from lending suggests that FIs need to
monitor and collect information about borrowers whose assets are in their portfolios and to monitor those borrowers over time. Thus, managerial monitoring efficiency and credit risk management strategies directly affect the return and risks
of the loan portfolio. Moreover, one of the advantages FIs have over individual
household investors is the ability to diversify some credit risk from a single asset
away by exploiting the law of large numbers in their asset investment portfolios
(see Chapter 1). Diversification across assets, such as loans exposed to credit risk,
reduces the overall credit risk in the asset portfolio and thus increases the probability of partial or full repayment of principal and/or interest.
FIs earn the maximum dollar return when all bonds and loans pay off interest
and principal in full. In reality, some loans or bonds default on interest payments,
principal payments, or both. Thus, the mean return on the asset portfolio would
be less than the maximum possible. The effect of risk diversification is to truncate
or limit the probabilities of the bad outcomes in the portfolio. In effect, diversification reduces individual firm-specific credit risk, such as the risk specific to
holding the bonds or loans of General Motors, while leaving the FI still exposed
to systematic credit risk, such as factors that simultaneously increase the default
risk of all firms in the economy (e.g., an economic recession). We describe methods
to measure the default risk of individual corporate claims such as bonds and loans
in Chapter 10. In Chapter 11, we investigate methods of measuring the risk in
portfolios of such claims. Chapter 25 discusses various methods—for example,
loan sales, reschedulings, and a good bank–bad bank structure—to manage and
control credit risk exposures better, while Chapters 22, 23, 24, and 26 discuss the
role of the credit derivative markets in hedging credit risk.
1. Why does credit risk exist for FIs?
2. How does diversification affect an FI’s credit risk exposure?
LIQUIDITY RISK
liquidity risk
The risk that a sudden
surge in liability withdrawals may leave
an FI in a position of
having to liquidate
assets in a very short
period of time and at
low prices.
Liquidity risk arises when an FI’s liability holders, such as depositors or insurance
policyholders, demand immediate cash for the financial claims they hold with an
FI or when holders of off-balance-sheet loan commitments (or credit lines) suddenly exercise their right to borrow (draw down their loan commitments). For
example, when liability holders demand cash immediacy—that is, “put” their
financial claims back to the FI—the FI must either borrow additional funds or sell
assets to meet the demand for the withdrawal of funds. The most liquid asset of
3
In the early 2000s, the U.S. Congress considered and passed legislation that made it more difficult for
individuals to declare bankruptcy. This congressional activity brought about a rise in bankruptcy filings
before changes took effect.
Chapter 7
www.fdic.gov
EXAMPLE 7–3
Impact of
Liquidity Risk
on an FI’s Equity
Value
Risks of Financial Institutions
179
all is cash, which FIs can use to directly meet liability holders’ demands to withdraw funds. Although FIs limit their cash asset holdings because cash earns no
interest, low cash holdings are usually not a problem. Day-to-day withdrawals by
liability holders are generally predictable, and FIs can normally expect to borrow
additional funds to meet any sudden shortfalls of cash on the money and financial
markets.
However, there are times when an FI can face a liquidity crisis. Because of
a lack of confidence by liability holders in the FI or some unexpected need for
cash, liability holders may demand larger withdrawals than normal. When all, or
many, FIs face abnormally large cash demands, the cost of additional purchased
or borrowed funds rises and the supply of such funds becomes restricted. As
a consequence, FIs may have to sell some of their less liquid assets to meet the
withdrawal demands of liability holders. This results in a more serious liquidity
risk, especially as some assets with “thin” markets generate lower prices when
the asset sale is immediate than when the FI has more time to negotiate the sale
of an asset. As a result, the liquidation of some assets at low or fire-sale prices
(the price an FI receives if an asset must be liquidated immediately at less than its
fair market value) could threaten an FI’s profitability and solvency. For example,
in the summer of 2008 IndyMac bank failed, in part due to a bank run that continued for several days, even after being taken over by the FDIC. The bank had
announced on July 7 that, due to its deteriorating capital position, its mortgage
operations would stop and it would operate only as a retail bank. News reports
over the weekend highlighted the possibility that IndyMac would become the
largest bank failure in over 20 years. Worried that they would not have access
to their money, bank depositors rushed to withdraw money from IndyMac even
though their deposits were insured up to $100,000 by the FDIC.4 The run was so
large that within a week of the original announcement, the FDIC had to step in
and take over the bank.
Consider the simple FI balance sheet in Table 7–2. Before deposit withdrawals, the FI has
$10 million in cash assets and $90 million in nonliquid assets (such as small business loans).
These assets were funded with $90 million in deposits and $10 million in owner’s equity.
Suppose that depositors unexpectedly withdrew $15 million in deposits (perhaps due to the
release of negative news about the profits of the FI) and the FI receives no new deposits to
replace them. To meet these deposit withdrawals, the FI first uses the $10 million it has in
cash assets and then seeks to sell some of its nonliquid assets to raise an additional $5 million
in cash. Assume that the FI cannot borrow any more funds in the short-term money markets,
and because it cannot wait to get better prices for its assets in the future (as it needs the
cash now to meet immediate depositor withdrawals), the FI has to sell any nonliquid assets
at 50 cents on the dollar. Thus, to cover the remaining $5 million in deposit withdrawals, the
FI must sell $10 million in nonliquid assets, incurring a loss of $5 million from the face value
of those assets. The FI must then write off any such losses against its capital or equity funds.
Because its capital was only $10 million before the deposit withdrawal, the loss on the firesale of assets of $5 million leaves the FI with only $5 million in equity.
4
One reason is that, although deposits were insured up to $100,000 (since increased to $250,000), it
may take some days to transfer deposits to the bank of an acquirer. IndyMac was eventually acquired by
OneWest Bank Group.
180
Part One
Introduction
TABLE 7–2
Adjusting to a
Deposit Withdrawal
Using Asset Sales
(in millions)
Before the Withdrawal
Assets
Cash assets
Nonliquid assets
After the Withdrawal
Liabilities/Equity
$ 10
90
$100
Deposit
Equity
$ 90
10
$100
Assets
Cash assets
Nonliquid assets
Liabilities/Equity
$ 0
80
Deposits
Equity
$80
$ 75
5
$ 80
We examine the nature of normal, abnormal, and run-type liquidity risks and
their impact on FIs in more detail in Chapter 12. In addition, we look at ways an FI
can better manage liquidity and liability risk exposures in Chapter 18. Chapter 19
discusses the roles of deposit insurance and other liability guarantee schemes in
deterring deposit (liability) runs.
Concept
Questions
1. Why might an FI face a sudden liquidity crisis?
2. What circumstances might lead an FI to liquidate assets at fire-sale prices?
FOREIGN EXCHANGE RISK
£ ¥
:$
foreign exchange
risk
The risk that
exchange rate changes
can affect the value of
an FI’s assets and liabilities denominated
in foreign currencies.
Increasingly, FIs have recognized that both direct foreign investment and foreign
portfolio investments can extend the operational and financial benefits available
from purely domestic investments. Thus, U.S. pension funds that held approximately 5 percent of their assets in foreign securities in the early 1990s now hold
over 12 percent of their assets in foreign securities. At the same time, many large
U.S. banks, investment banks, and mutual funds have become more global in their
orientation. To the extent that the returns on domestic and foreign investments
are imperfectly correlated, there are potential gains for an FI that expands its asset
holdings and liability funding beyond the domestic borders.
The returns on domestic and foreign direct investing and portfolio investments are not perfectly correlated for two reasons. The first is that the underlying technologies of various economies differ, as do the firms in those economies.
For example, one economy may be based on agriculture while another is industry
based. Given different economic infrastructures, one economy could be expanding while another is contracting. In the early 2010s, for example, the U.S. economy
was expanding while the European economy was recessionary. The second reason
is that exchange rate changes are not perfectly correlated across countries. This
means the dollar–euro exchange rate may be appreciating while the dollar–yen
exchange rate may be falling.
One potential benefit from an FI’s becoming increasingly global in its outlook is
an ability to expand abroad directly through branching or acquisitions or by developing a financial asset portfolio that includes foreign securities as well as domestic
securities. Even so, foreign investment exposes an FI to foreign exchange risk.
Foreign exchange risk is the risk that exchange rate changes can adversely affect
the value of an FI’s assets and liabilities denominated in foreign currencies.
Chapter 7
Risks of Financial Institutions
181
To understand how foreign exchange risk arises, suppose that a U.S. FI makes
a loan to a British company in pounds (£). Should the British pound depreciate in
value relative to the U.S. dollar, the principal and interest payments received by
U.S. investors would be devalued in dollar terms. Indeed, were the British pound
to fall far enough over the investment period, when cash flows are converted back
into dollars, the overall return could be negative. That is, on the conversion of
principal and interest payments from pounds into dollars, foreign exchange losses
can offset the promised value of local currency interest payments at the original
exchange rate at which the investment occurred.
In general, an FI can hold assets denominated in a foreign currency and/or
issue foreign liabilities. Consider a U.S. FI that holds £100 million in pound loans
as assets and funds £80 million of them with pound certificates of deposit. The
difference between the £100 million in pound loans and £80 million in pound CDs
is funded by dollar CDs (i.e., £20 million worth of dollar CDs). See Figure 7–2. In
this case, the U.S. FI is net long £20 million in pound assets; that is, it holds more
foreign assets than liabilities. The U.S. FI suffers losses if the exchange rate for
pounds falls or depreciates against the dollar over this period. In dollar terms, the
value of the pound loan assets falls or decreases in value by more than the pound
CD liabilities do. That is, the FI is exposed to the risk that its net foreign assets may
have to be liquidated at an exchange rate lower than the one that existed when the
FI entered into the foreign asset–liability position.
Instead, the FI could have £20 million more pound liabilities than assets; in
this case, it would be holding a net short position in pound assets, as shown in
Figure 7–3. Under this circumstance, the FI is exposed to foreign exchange risk if
the pound appreciates against the dollar over the investment period. This occurs
because the value of its pound liabilities in dollar terms rose faster than the return
on its pound assets. Consequently, to be approximately hedged, the FI must match
its assets and liabilities in each foreign currency.
Note that the FI is fully hedged only if we assume that it holds foreign assets and
liabilities of exactly the same maturity.5 Consider what happens if the FI matches the
size of its foreign currency book (Pound assets ⫽ Pound liabilities ⫽ £100 million
in that currency) but mismatches the maturities so that the pound assets are of
FIGURE 7–2
The Foreign Asset
and Liability
Position: Net Long
Asset Position in
Pounds
0
Foreign assets
£100 million
0
Foreign liabilities
£80 million
0
Foreign assets
£80 million
FIGURE 7–3
The Foreign Asset
and Liability
Position: Net Short
Asset Position in
Pounds
0
5
Foreign liabilities
£100 million
Technically speaking, hedging requires matching the durations (average lives of assets and liabilities)
rather than simple maturities (see Chapter 9).
182
Part One
Introduction
six-month maturity and the liabilities are of three-month maturity. The FI would
then be exposed to foreign interest rate risk—the risk that British interest rates
would rise when it has to roll over its £100 million in pound CD liabilities at the
end of the third month. Consequently, an FI that matches both the size and maturities of its exposure in assets and liabilities of a given currency is hedged, or immunized, against foreign currency and foreign interest rate risk. To the extent that
FIs mismatch their portfolio and maturity exposures in different currency assets
and liabilities, they face both foreign currency and foreign interest rate risks. As
already noted, if foreign exchange rate and interest rate changes are not perfectly
correlated across countries, an FI can diversify away part, if not all, of its foreign
currency risk. We discuss the measurement and evaluation of an FI’s foreign currency risk exposure in depth in Chapter 13.
Concept
Questions
1. Explain why the returns on domestic and foreign portfolio investments are not, in
general, perfectly correlated.
2. A U.S. bank is net long in European assets. If the euro appreciates against the dollar,
will the bank gain or lose?
COUNTRY OR SOVEREIGN RISK
£ ¥
:$
country or
sovereign risk
The risk that repayments from foreign
borrowers may be
interrupted because
of interference from
foreign governments.
As we noted in the previous section, a globally oriented FI that mismatches the
size and maturities of its foreign assets and liabilities is exposed to foreign currency and foreign interest rate risks. Even beyond these risks, and even when
investing in dollars, holding assets in a foreign country can expose an FI to an
additional type of foreign investment risk called country or sovereign risk.
Country or sovereign risk is a different type of credit risk that is faced by an FI
that purchases assets such as the bonds and loans of foreign corporations. For
example, when a domestic corporation is unable or unwilling to repay a loan, an
FI usually has recourse to the domestic bankruptcy courts and eventually may
recoup at least a portion of its original investment when the assets of the defaulted
firm are liquidated or restructured. By comparison, a foreign corporation may be
unable to repay the principal or interest on a loan even if it would like to. Most
commonly, the government of the country in which the corporation is headquartered may prohibit or limit debt payments because of foreign currency shortages
and adverse political reasons.
For example, in 2001, the government of Argentina, which had pegged its peso
to the dollar on a one-to-one basis since the early 1990s, had to default on its government debt largely because of an overvalued peso and the adverse effect this
had on its exports and foreign currency earnings. In December 2001, Argentina
ended up defaulting on $130 billion in government-issued debt and, in 2002,
passed legislation that led to defaults on $30 billion of corporate debt owed to foreign creditors. Argentina’s economic problems continued into the mid-2000s. In
September 2003 it defaulted on a $3 billion loan repayment to the IMF and in 2005
Argentina announced that it was offering its creditors about 30 cents on the dollar from its 2001 debt restructuring of $103 billion. More recently, despite massive
injections of bailout funds by the eurozone and the International Monetary Fund,
Chapter 7
Risks of Financial Institutions
183
in March 2012, Greek government debtholders lost 53.5 percent of their $265 billion investment as Greece restructured much of its sovereign debt. The restructuring produced the largest-ever sovereign debt default.
In the event of such restrictions, reschedulings, or outright prohibitions on the
payment of debt obligations by sovereign governments, the FI claimholder has
little, if any, recourse to the local bankruptcy courts or an international civil claims
court. The major leverage available to an FI to ensure or increase repayment probabilities and amounts is its control over the future supply of loans or funds to the
country concerned. However, such leverage may be very weak in the face of a
country’s collapsing currency and government. Chapter 14 discusses how country
or sovereign risk is measured and considers possible financial market solutions to
the country risk exposure problems of a globally oriented FI.
Concept
Questions
1. Can an FI be subject to sovereign risk if it lends only to the highest-quality foreign
corporations?
2. What is one major way an FI can discipline a country that threatens not to repay its loans?
MARKET RISK
market risk
The risk incurred in
the trading of assets
and liabilities due to
changes in interest
rates, exchange rates,
and other asset prices.
Market risk arises when FIs actively trade assets and liabilities (and derivatives)
rather than hold them for longer-term investment, funding, or hedging purposes.
Market risk is closely related to interest rate risk, credit risk, and foreign exchange
risk in that as these risks increase or decrease, the overall risk of the FI is affected.
However, market risk adds another dimension resulting from its trading activity.
Market risk is the incremental risk incurred by an FI when interest rate, foreign
exchange, and credit risks are combined with an active trading strategy, especially one that involves short trading horizons such as a day. Conceptually, an FI’s
trading portfolio can be differentiated from its investment portfolio on the basis
of time horizon and secondary market liquidity. The trading portfolio contains
assets, liabilities, and derivative contracts that can be quickly bought or sold on
organized financial markets. The investment portfolio (or in the case of banks, the
so-called banking book) contains assets and liabilities that are relatively illiquid
and held for longer holding periods. Table 7–3 shows a hypothetical breakdown
TABLE 7–3
The Investment
(Banking) Book and
Trading Book of a
Commercial Bank
Banking book
Trading book
Assets
Cash
Loans
Premises and equipment
Other illiquid assets
Liabilities
Deposits
Other illiquid borrowed funds
Capital
Bonds (long)
Commodities (long)
FX (long)
Equities (long)
Bonds (short)
Commodities (short)
FX (short)
Equities (short)
Derivatives* (long)
Derivatives* (short)
*Derivatives are off-balance-sheet items (as discussed in Chapter 16).
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between banking book and trading book assets and liabilities. As can be seen,
the banking book contains the majority of loans and deposits plus other illiquid
assets. The trading book contains long and short positions in instruments such as
bonds, commodities, foreign exchange (FX), equities, and derivatives.
With the increasing securitization of bank loans (e.g., mortgages), more and
more assets have become liquid and tradable. Of course, with time, every asset
and liability can be sold. While bank regulators have normally viewed tradable
assets as those being held for horizons of less than one year, private FIs take an
even shorter-term view. In particular, FIs are concerned about the fluctuation in
the value of their trading account assets and liabilities for periods as short as one
day especially if such fluctuations pose a threat to their solvency.
An extreme case of the type of risk involved in active trading is, of course,
the market meltdown of 2008–2009. As mortgage borrowers defaulted on their
mortgages, financial institutions that held these mortgages and mortgage-backed
securities started announcing huge losses on them. It is these securitized loans,
and particularly securitized subprime mortgage loans, that led to huge financial
losses resulting from market risk. Investment banks and securities firms were
major purchasers of mortgage originators in the early 2000s, which allowed them
to increase their business of packaging the loans as securities. As mortgage borrowers defaulted on their mortgages, the securitized mortgage market froze up
and FIs were left to hold these “toxic” assets at deeply reduced market values.
Investment banks were particularly hard hit with huge losses on the mortgages
and securities backing them. On Monday, September 15, Lehman Brothers (the
158-year-old investment bank) filed for bankruptcy, Merrill Lynch was bought
by Bank of America, AIG (one of the world’s largest insurance companies) met
with federal regulators to raise desperately needed cash, and Washington Mutual
(the largest savings institution in the United States) was acquired by J.P. Morgan
Chase. A sense of foreboding gripped Wall Street. The Dow fell more than
500 points, the largest drop in over seven years. World stock markets saw huge
swings in value as investors tried to sort out who might survive (markets from
Russia to Europe were forced to suspend trading as stock prices plunged). By
mid-September, financial markets froze and banks stopped lending to each other
at anything but exorbitantly high rates. Banks that were active traders faced
extreme market risk.
The financial market crisis illustrates that market, or trading, risk is present whenever an FI takes an open or unhedged long (buy) or sell (short) position in bonds, equities, foreign exchange, and derivative products, and prices
change in a direction opposite to that expected. As a result, the more volatile
are asset prices in the markets in which these instruments trade, the greater are
the market risks faced by FIs that adopt open trading positions. This requires FI
management (and regulators) to establish controls to limit positions taken by
traders as well as to develop models to measure the market risk exposure of an
FI on a day-to-day basis. These market risk measurement models are discussed
in Chapter 15.
Concept
Questions
1. What is market, or trading, risk?
2. What modern conditions have led to an increase in this particular type of risk for FIs?
Chapter 7
Risks of Financial Institutions
185
OFF-BALANCE-SHEET RISK
off-balance-sheet
risk
The risk incurred by
an FI due to activities
related to contingent
assets and liabilities.
letter of credit
A credit guarantee
issued by an FI for
a fee on which payment is contingent
on some future event
occurring.
One of the most striking trends for many modern FIs has been the growth in
their off-balance-sheet activities and thus their off-balance-sheet risk. While
all FIs to some extent engage in off-balance-sheet activities, most attention has
been drawn to the activities of banks, especially large banks, who invest heavily in off-balance-sheet assets and liabilities, particularly derivative securities.
By contrast, off-balance-sheet activities have been less of a concern to smaller
depository institutions and many insurance companies, who hold relatively few
off-balance-sheet securities. An off-balance-sheet activity, by definition, does
not appear on an FI’s current balance sheet since it does not involve holding a
current primary claim (asset) or the issuance of a current secondary claim (liability). Instead, off-balance-sheet activities affect the future shape of an FI’s balance sheet in that they involve the creation of contingent assets and liabilities
that give rise to their potential (future) placement on the balance sheet. Thus,
accountants place them “below the bottom line” of an FI’s asset and liability
balance sheet.
A good example of an off-balance-sheet activity is the issuance of standby
letter of credit guarantees by insurance companies and banks to back the issuance of municipal bonds. Many state and local governments could not issue such
securities without bank or insurance company letter of credit guarantees that promise principal and interest payments to investors should the municipality default
on its future obligations. Thus, the letter of credit guarantees payment should a
municipal government (e.g., New York State) face financial problems in paying
the promised interest payments and/or the principal on the bonds it issues. If a
municipal government’s cash flow is sufficiently strong so as to pay off the principal and interest on the debt it issues, the letter of credit guarantee issued by the FI
expires unused. Nothing appears on the FI’s balance sheet today or in the future.
However, the fee earned for issuing the letter of credit guarantee appears on the
FI’s income statement.
As a result, the ability to earn fee income while not loading up or expanding the
balance sheet has become an important motivation for FIs to pursue off-balancesheet business. Unfortunately, this activity is not risk free. Suppose the municipal
government defaults on its bond interest and principal payments. Then the contingent liability or guaranty the FI issued becomes an actual liability that appears
on the FI’s balance sheet. That is, the FI has to use its own equity to compensate
investors in municipal bonds.
Letters of credit are just one example of off-balance-sheet activities. Others
include loan commitments by banks, mortgage servicing contracts by depository institutions, and positions in forwards, futures, swaps, and other derivative
securities by almost all large FIs. While some of these activities are structured to
reduce an FI’s exposure to credit, interest rate, or foreign exchange risks, mismanagement or speculative use of these instruments can result in major losses to
FIs. Indeed, as seen during the financial crisis of 2008–2009, significant losses in
off-balance-sheet activities (e.g., credit default swaps) can cause an FI to fail, just
as major losses due to balance sheet default and interest rate risks can cause an
FI to fail.
We detail the specific nature of the risks of off-balance-sheet activities more
fully in Chapter 16. We look at how some of these instruments (forwards, futures,
options, and swaps) can be used to manage risks in Chapters 22, 23, 24, and 26.
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EXAMPLE 7–4
Impact of OffBalance-Sheet
Risk on an FI’s
Equity Value
Consider Table 7–4. In Panel A, the value of the FI’s net worth (E ) is calculated in the traditional way as the difference between the market values of its on-balance-sheet assets (A) and
liabilities (L):
E⫽A⫺L
10 ⫽ 100 ⫺ 90
Under this calculation, the market value of the stockholders’ equity stake in the FI is 10 and
the ratio of the FI’s capital to assets is 10 percent. Regulators and FIs often use the latter ratio
as a simple measure of solvency (see Chapter 20 for more details).
A more accurate picture of the FI’s economic solvency should consider the market values of
both its on-balance-sheet and OBS activities (Panel B of Table 7–4). Specifically, the FI manager
should value contingent or future asset and liability claims as well as current assets and liabilities.
In our example, the current market value of the FI’s contingent assets (CA) is 50; the current market value of its contingent liabilities (CL) is 55. Since CL exceed CA by 5, this difference is an additional obligation, or claim, on the FI’s net worth. That is, stockholders’ true net worth (E) is really:
E ⫽ (A ⫺ L) ⫹ (CA ⫺ CL)
⫽ (100 ⫺ 90) ⫹ (50 ⫺ 55) ⫽ 5
rather than 10 when we ignored off-balance-sheet activities. Thus, economically speaking,
contingent assets and liabilities are contractual claims that directly impact the economic value
of the equity holders’ stake in an FI. Indeed, from both the stockholders’ and regulators’ perspectives, large increases in the value of OBS liabilities can render the FI economically insolvent just as effectively as losses due to mismatched interest rate gaps and default or credit
losses from on-balance-sheet activities.
TABLE 7–4
Valuation of an
FI’s Net Worth
with and without
Consideration of
Off-Balance-Sheet
Activities
Panel A: Traditional Valuation of an FI’s Net Worth
Market value of assets (A)
Market value of liabilities (L)
Net worth (E )
100
90
10
100
Panel B: Valuation of an FI’s Net Worth with On- and Off-Balance-Sheet
Activities Valued
Market value of assets (A)
Market value of contingent
assets (CA)
Concept
Questions
100
100
50
150
Market value of liabilities (L)
Net worth (E )
Market value of contingent
liabilities (CL)
90
5
55
150
1. Why are letter of credit guarantees an off-balance-sheet item?
2. Why are FIs motivated to pursue off-balance-sheet business? What are the risks?
TECHNOLOGY AND OPERATIONAL RISKS
www.bis.org
Technology and operational risks are closely related and in recent years have caused
great concern to FI managers and regulators alike. The Bank for International Settlements (BIS), the principal organization of central banks in the major economies
Chapter 7
economies of scale
The degree to which
an FI’s average unit
costs of producing
financial services fall
as its outputs of services increase.
economies of scope
The degree to which
an FI can generate
cost synergies by
producing multiple financial service
products.
technology risk
The risk incurred by
an FI when technological investments do
not produce the cost
savings anticipated.
operational risk
The risk that existing
technology or support systems may
malfunction or break
down.
Risks of Financial Institutions
187
of the world, defines operational risk (inclusive of technological risk) as “the risk
of loss resulting from inadequate or failed internal processes, people, and systems
or from external events.”6 A number of FIs add reputational risk and strategic risk
(e.g., due to a failed merger) as part of a broader definition of operational risk.
Technological innovation was a major growth area of FIs in the 1990s and 2000s.
Banks, insurance companies, and investment companies all sought to improve
operational efficiency with major investments in internal and external communications, computers, and an expanded technological infrastructure. For example,
most banks provide depositors with the capabilities to check account balances,
transfer funds between accounts, manage finances, pay bills, and perform other
functions from their home personal computers. At the wholesale level, electronic
transfer of funds through automated clearing houses (ACH) and wire transfer payment networks such as the Clearing House Interbank Payments Systems
(CHIPS) have been developed. Indeed, the global financial services firm Citigroup
has operations in more than 100 countries connected in real time by a proprietaryowned satellite system.
The major objectives of technological expansion are to lower operating costs,
increase profits, and capture new markets for the FI. In current terminology, the
objective is to allow the FI to exploit, to the fullest extent possible, better potential
economies of scale and economies of scope in selling its products. Economies of
scale refer to an FI’s ability to lower its average costs of operations by expanding
its output of financial services. Economies of scope refer to an FI’s ability to generate cost synergies by producing more than one output with the same inputs. For
example, an FI could use the same information on the quality of customers stored
in its computers to expand the sale of both loan products and insurance products.
That is, the same information (e.g., age, job, size of family, income) can identify
both potential loan and life insurance customers.
Technology risk occurs when technological investments do not produce the anticipated cost savings in the form of economies of either scale or scope. Diseconomies
of scale, for example, arise because of excess capacity, redundant technology, and/
or organizational and bureaucratic inefficiencies that become worse as an FI grows
in size. Diseconomies of scope arise when an FI fails to generate perceived synergies
or cost savings through major new technological investments. We describe the measurement and evidence of economies of scale and scope in FIs in Chapter 17. Technological risk can result in major losses in the competitive efficiency of an FI and,
ultimately, in its long-term failure. Similarly, gains from technological investments
can produce performance superior to an FI’s rivals as well as allow it to develop
new and innovative products, enhancing its long-term survival chances.
Operational risk is partly related to technology risk and can arise whenever
existing technology malfunctions or back-office support systems break down. For
example, the biggest known theft of credit card numbers was discovered in May
2007, when, over a two-year period, as many as 200 million card numbers were
stolen from TJX Company—parent company to such retail stores as Marshalls and
TJ Maxx. The retailer’s wireless network reportedly had less security than most
home networks. Even though such computer breakdowns are rare, their occurrence can cause major dislocations in the FIs involved and potentially disrupt the
financial system in general.
6
See Basel Committee on Bank Supervision, “Sound Practices for the Management and Supervision of
Operational Risk,” July 2002, p. 2, Basel, Switzerland.
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Operational risk is not exclusively the result of technological failure. For example, employee fraud and errors constitute a type of operational risk that often negatively affects the reputation of an FI (see Chapter 17). A good example involves
$2 billion in trading losses incurred by J.P. Morgan Chase’s trader, Bruno Iksil,
also known as “the London Whale,” who had taken large credit default swap
(CDS) positions in expectation that the financial crisis in Europe would cause
anxiety in financial markets. Instead, bailouts, austerity measures, and interventions prevented any major events in Europe. To maintain the proper balance and
deal with expiring contracts, Iksil needed to continually make new trades. But the
CDS market was too small and the amounts Iksil was trading were too large to let
J.P. Morgan operate in secrecy. Once the story got out, hedge funds traders took
positions designed to gain from the trades that Iksil had to make to keep the position going. That activity negatively altered prices on the CDSs that Iksil needed.
Eventually, the only choice was to close the CDS position and take the loss. These
activities by employees of FIs result in an overall loss of reputation and, in turn,
business for the FI employers.
Concept
Questions
1. What is the difference between economies of scale and economies of scope?
2. How is operational risk related to technology risk?
3. How does technological expansion help an FI better exploit economies of scale and
economies of scope? When might technology risk interfere with these goals?
INSOLVENCY RISK
insolvency risk
The risk that an FI
may not have enough
capital to offset a
sudden decline in the
value of its assets relative to its liabilities.
Insolvency risk is a consequence or outcome of one or more of the risks described
above: interest rate, credit, liquidity, foreign exchange, sovereign, market, offbalance-sheet, and technology risks. Technically, insolvency occurs when the capital or equity resources of an FI’s owners are driven to, or near to, zero because
of losses incurred as the result of one or more of the risks described above.
Consider the case of Washington Mutual (WaMu), which incurred heavy losses
from its on- and off-balance-sheet holdings during the financial crisis. By early
September 2008, WaMu’s market capital was worth only $3.5 billion, down from
$43 billion at the end of 2006. In September 2008, the bank was taken over by the
FDIC and sold to J.P. Morgan Chase. In contrast, in March 2009, Citigroup’s stock
price fell to below $1 per share, and the once largest bank in the United States
was near failure. Proving that some banks are too big to fail, Citigroup received
a substantial government guarantee against losses (up to $306 billion) and a
$20 billion injection of cash to prevent failure. Indeed, through December 2009
more than 700 banks had received a total of $205 billion in federal government
funds (through the Capital Purchase Program) in an effort to prop up capital and
support lending.
In general, the more equity capital to borrowed funds an FI has—that is, the
lower its leverage—the better able it is to withstand losses, whether due to adverse
interest rate changes, unexpected credit losses, or other reasons. Thus, both management and regulators of FIs focus on an FI’s capital (and adequacy) as a key
measure of its ability to remain solvent and grow in the face of a multitude of
risk exposures. The issue of what is an adequate level of capital to manage an FI’s
overall risk exposure is discussed in Chapter 20.
Chapter 7
Concept
Questions
Risks of Financial Institutions
189
1. When does insolvency risk occur?
2. How is insolvency risk related to the other risks discussed in this chapter?
OTHER RISKS AND THE INTERACTION OF RISKS
In this chapter we have concentrated on 10 major risks continuously affecting an
FI manager’s decision-making process and risk management strategies. These risks
were interest rate risk, credit risk, liquidity risk, foreign exchange risk, country or
sovereign risk, market risk, off-balance-sheet risk, technology and operational risk,
and insolvency risk. Even though the discussion generally described each independently, in reality, these risks are often interdependent. For example, when interest
rates rise, corporations and consumers find maintaining promised payments on
their debt more difficult. Thus, over some range of interest rate movements, credit,
interest rate, and off-balance-sheet risks are positively correlated. Furthermore, the
FI may have been counting on the funds from promised payments on its loans for
liquidity management purposes. Thus, liquidity risk is also correlated with interest
rate and credit risks. The inability of a customer to make promised payments also
affects the FI’s income and profits and, consequently, its equity or capital position.
Thus, each risk and its interaction with other risks ultimately affects insolvency risk.
Similarly, foreign exchange rate changes and interest rate changes are also highly correlated. When the Federal Reserve changes a key interest rate (such as the Fed funds
rate) through its monetary policy actions, exchange rates are also likely to change.
Various other risks, often of a more discrete or event type, also impact an FI’s
profitability and risk exposure, although, as noted earlier, many view discrete or
event risks as part of operational risks. Discrete risks might include events external
to the FI, such as a sudden change in regulation policy. These include lifting the regulatory barriers to lending or to entry or on products offered (see Chapter 21). The
1994 regulatory change allowing interstate branching after 1997 is one example, as
are the 1999 Financial Services Modernization Act and the Wall Street Reform and
Consumer Protection Act of 2010. Other discrete or event risks involve sudden and
unexpected changes in financial market conditions due to war, revolution, or sudden market collapse, such as the 1929 and 2008 stock market crashes or the September 2001 terrorist attacks in the United States. These can have a major impact on
an FI’s risk exposure. Other event risks include fraud, theft, earthquakes, storms,
malfeasance, and breach of fiduciary trust; all of these can ultimately cause an FI to
fail or be severely harmed. Yet each is difficult to model and predict.
Finally, more general macroeconomic or systematic risks, such as increased
inflation, inflation volatility, and unemployment, can directly and indirectly
impact an FI’s level of interest rate, credit, and liquidity risk exposure. For example, the U.S. unemployment rate was greater than 10 percent in the fall of 2009, the
highest level since September 1992. Since December 2007 (as the recession began)
the U.S. economy lost some 8 million jobs, most of which were lost in the period
November 2008 through June 2009. With so many people out of work, credit risk
exposure of FIs increased dramatically as borrowers had trouble keeping up with
their loan payments after losing their jobs.
Concept
Questions
1. What is meant by the term event risk?
2. What are some examples of event and general macroeconomic risks that impact FIs?
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Summary
This chapter provided an introductory view of 10 major risks faced by modern
FIs. They face interest rate risk when the maturities of their assets and liabilities
are mismatched. They face credit risk or default risk if their clients default on their
loans and other obligations. They encounter liquidity risk as a result of excessive
withdrawals or problems in refinancing liabilities. If FIs conduct foreign business,
they are subject to additional risks, namely, foreign exchange and sovereign risks.
They incur market risk on their trading assets and liabilities if adverse movements
in interest rates, exchange rates, or other asset prices occur. Modern-day FIs also
engage in significant off-balance-sheet activities that expose them to off-balancesheet risks: contingent asset and liability risks. The advent of sophisticated technology and automation exposes FIs to both technological and operational risks. FI’s face
insolvency risk when their capital is insufficient to withstand the losses that they
incur as a result of such risks. The interaction of the various risks means that FI
managers face making trade-offs among them. As they take actions in an attempt
to affect one type of risk, FI managers must consider the possible impact on other
risks. The effective management of these risks determines a modern FI’s success
or failure. The chapters that follow analyze each of these risks in greater detail.
Questions
and Problems
1. What is the process of asset transformation performed by a financial institution?
Why does this process often lead to the creation of interest rate risk? What is
interest rate risk?
2. What is refinancing risk? How is refinancing risk part of interest rate risk? If an
FI funds long-term assets with short-term liabilities, what will be the impact on
earnings of an increase in the rate of interest? A decrease in the rate of interest?
3. What is reinvestment risk? How is reinvestment risk part of interest rate risk?
If an FI funds short-term assets with long-term liabilities, what will be the
impact on earnings of a decrease in the rate of interest? An increase in the rate
of interest?
4. The sales literature of a mutual fund claims that the fund has no risk exposure
since it invests exclusively in federal government securities which are free of
default risk. Is this claim true? Explain why or why not.
5. How can interest rate risk adversely affect the economic or market value of
an FI?
6. Consider an FI that issues $100 million of liabilities with one year to maturity
to finance the purchase of $100 million of assets with a two-year maturity. Suppose that the cost of funds (liabilities) for the FI is 5 percent per year and the
interest return on the assets is 8 percent per year.
a. Calculate the FI’s profit spread and dollar value of profit in year 1.
b. Calculate the profit spread and dollar value of profit in year 2 if the FI can
refinance its liabilities at 5 percent.
c. If interest rates rise and the FI can borrow new one-year liabilities at 9 percent in the second year, calculate the FI’s profit spread and dollar value of
profit in year 2.
d. If interest rates fall and the FI can borrow new one-year liabilities at 3 percent in the second year, calculate the FI’s profit spread and dollar value of
profit in year 2.
Chapter 7
Risks of Financial Institutions
191
7. Consider an FI that issues $200 million of liabilities with two years to maturity
to finance the purchase of $200 million of assets with a one year maturity. Suppose that the cost of funds (liabilities) for the FI is 5 percent per year and the
interest return on the assets is 9 percent per year.
a. Calculate the FI’s profit spread and dollar value of profit in year 1.
b. Calculate the profit spread and dollar value of profit in year 2 if the FI can
reinvest its assets at 9 percent.
c. If interest rates fall and the FI can invest in one-year assets at 6 percent in the
second year, calculate the FI’s profit spread and dollar value of profit in year 2.
d. If interest rates rise and the FI can invest in one-year assets at 11 percent in
the second year, calculate the FI’s profit spread and dollar value of profit in
year 2.
8. A financial institution has the following market value balance sheet structure:
Cash
Bond
Total assets
Liabilities and Equity
$ 1,000
10,000
$11,000
Certificate of deposit
Equity
Total liabilities and equity
$10,000
1,000
$11,000
a. The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at
the end of each year, and a par value of $10,000. The certificate of deposit
has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects
no additional asset growth. What will be the net interest income at the end
of the first year? Note: Net interest income equals interest income minus
interest expense.
b. If at the end of year 1, market interest rates have increased 100 basis points
(1 percent), what will be the net interest income for the second year? Is this
result caused by reinvestment risk or refinancing risk?
c. Assuming that market interest rates increase 1 percent, the bond will have
a value of $9,446 at the end of year 1. What will be the market value of
equity for the FI? Assume that all of the NII in part (a) is used to cover
operating expenses or dividends.
d. If market interest rates had decreased 100 basis points by the end of year 1,
would the market value of equity be higher or lower than $1,000? Why?
e. What factors have caused the changes in operating performance and market
value for this firm?
9. How does a policy of matching the maturities of assets and liabilities work (a)
to minimize interest rate risk and (b) against the asset-transformation function
of FIs?
10. Corporate bonds usually pay interest semiannually. If a company decided to
change from semiannual to annual interest payments, how would this affect
the bond’s interest rate risk?
11. Two 10-year bonds are being considered for an investment that may have to
be liquidated before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon rate higher than its required rate of return, and the
second bond is a zero-coupon bond that pays only a lump-sum payment after
10 years with no interest over its life. Which bond would have more interest
rate risk? That is, which bond’s price would change by a larger amount for a
given change in interest rates? Explain your answer.
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Assets
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12. Consider again the two bonds in problem 11. If the investment goal is to leave
the assets untouched until maturity, such as for a child’s education or for one’s
retirement, which of the two bonds has more interest rate risk? What is the
source of this risk?
13. A money market mutual fund bought $1 million of two-year Treasury notes
six months ago. During this time, the value of the securities has increased,
but for tax reasons the mutual fund wants to postpone any sale for two more
months. What type of risk does the mutual fund face for the next two months?
14. A bank invested $50 million in a two-year asset paying 10 percent interest per
year and simultaneously issued a $50 million, one-year liability paying 8 percent interest per year. The liability will be rolled over after one year at the current market rate. What will be the impact on the bank’s net interest income if at
the end of the first year all interest rates have increased by 1 percent (100 basis
points)?
15. What is credit risk? Which types of FIs are more susceptible to this type of risk?
Why?
16. What is the difference between firm-specific credit risk and systematic credit risk?
How can an FI alleviate firm-specific credit risk?
17. Many banks and savings institutions that failed in the 1980s had made loans to
oil companies in Louisiana, Texas, and Oklahoma. When oil prices fell, these
companies, the regional economy, and the banks and savings institutions all
experienced financial problems. What types of risk were inherent in the loans
that were made by these banks and savings institutions?
18. What is liquidity risk? What routine operating factors allow FIs to deal with
this risk in times of normal economic activity? What market reality can create
severe financial difficulty for an FI in times of extreme liquidity crises?
19. Consider the simple FI balance sheet below (in millions of dollars).
Before the Withdrawal
Assets
Cash assets
Nonliquid Assets
Liabilities/Equity
$ 20
155
www.mhhe.com/saunders8e
$175
Deposit
Equity
$150
25
$175
Suppose that depositors unexpectedly withdraw $50 million in deposits and
the FI receives no new deposits to replace them. Assume that the FI cannot
borrow any more funds in the short-term money markets, and because it cannot wait to get better prices for its assets in the future (as it needs the cash now
to meet immediate depositor withdrawals), the FI has to sell any nonliquid
assets at 75 cents on the dollar. Show the FI’s balance sheet after adjustments
are made for the $50 million of deposit withdrawals.
20. What two factors provide potential benefits to FIs that expand their asset
holdings and liability funding sources beyond their domestic borders?
21. What is foreign exchange risk? What does it mean for an FI to be net long in
foreign assets? What does it mean for an FI to be net short in foreign assets? In
each case, what must happen to the foreign exchange rate to cause the FI to
suffer losses?
Risks of Financial Institutions
193
22. If the Swiss franc is expected to depreciate in the near future, would a U.S.-based
FI in Bern City prefer to be net long or net short in its asset positions? Discuss.
23. If international capital markets are well integrated and operate efficiently,
will FIs be exposed to foreign exchange risk? What are the sources of foreign
exchange risk for FIs?
24. If an FI has the same amount of foreign assets and foreign liabilities in the
same currency, has that FI necessarily reduced the risk involved in these international transactions to zero? Explain.
25. A U.S. insurance company invests $1,000,000 in a private placement of British bonds. Each bond pays £300 in interest per year for 20 years. If the current exchange rate is £1.564/$, what is the nature of the insurance company’s
exchange rate risk? Specifically, what type of exchange rate movement concerns this insurance company?
26. Assume that a bank has assets located in London that are worth £150 million
on which it earns an average of 8 percent per year. The bank has £100 million
in liabilities on which it pays an average of 6 percent per year. The current
spot exchange rate is £1.50/$.
a. If the exchange rate at the end of the year is £2.00/$, will the dollar have
appreciated or depreciated against the pound?
b. Given the change in the exchange rate, what is the effect in dollars on the
net interest income from the foreign assets and liabilities? Note: The net
interest income is interest income minus interest expense.
c. What is the effect of the exchange rate change on the value of assets and
liabilities in dollars?
27. Six months ago, Qualitybank issued a $100 million, one-year maturity CD
denominated in euros. On the same date, $60 million was invested in a
:-denominated loan and $40 million was invested in a U.S. Treasury bill. The
exchange rate on this date was :1.5675/$. Assume no repayment of principal
and an exchange rate today of :1.2540/$.
a. What is the current value of the CD principal (in euros and dollars)?
b. What is the current value of the euro-denominated loan principal (in dollars
and euros)?
c. What is the current value of the U.S. Treasury bill (in euros and dollars)?
d. What is Qualitybank’s profit/loss from this transaction (in euros and dollars)?
28. Suppose you purchase a 10-year, AAA-rated Swiss bond for par that is paying
an annual coupon of 6 percent. The bond has a face value of 1,000 Swiss francs
(SF). The spot rate at the time of purchase is SF1.15/$. At the end of the year,
the bond is downgraded to AA and the yield increases to 8 percent. In addition, the SF appreciates to SF1.05/$.
a. What is the loss or gain to a Swiss investor who holds this bond for a year?
What portion of this loss or gain is due to foreign exchange risk? What portion is due to interest rate risk?
b. What is the loss or gain to a U.S. investor who holds this bond for a year?
What portion of this loss or gain is due to foreign exchange risk? What portion is due to interest rate risk?
29. What is country or sovereign risk? What remedy does an FI realistically have in
the event of a collapsing country or currency?
30. What is market risk? How does this risk affect the operating performance of
financial institutions? What actions can be taken by an FI’s management to
minimize the effects of this risk?
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Part One
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31. What is the nature of an off-balance-sheet activity? How does an FI benefit
from such activities? Identify the various risks that these activities generate
for an FI, and explain how these risks can create varying degrees of financial
stress for the FI at a later time.
32. What is technology risk? What is the difference between economies of scale and
economies of scope? How can these economies create benefits for an FI? How
can these economies prove harmful to an FI?
33. What is the difference between technology risk and operational risk? How does
internationalizing the payments system among banks increase operational
risk?
34. Why can insolvency risk be classified as a consequence or outcome of any or all
of the other types of risks?
35. Discuss the interrelationships among the different sources of FI risk exposure.
Why would the construction of an FI risk management model to measure and
manage only one type of risk be incomplete?
36. Characterize the risk exposure(s) of the following FI transactions by choosing
one or more of the risk types listed below:
a. Interest rate risk
b. Credit risk
c. Off-balance-sheet risk
d. Technology risk
e. Foreign exchange risk
f. Country or sovereign risk
(1) A bank finances a $10 million, six-year fixed-rate commercial loan by
selling one-year certificates of deposit.
(2) An insurance company invests its policy premiums in a long-term
municipal bond portfolio.
(3) A French bank sells two-year fixed-rate notes to finance a two-year
fixed-rate loan to a British entrepreneur.
(4) A Japanese bank acquires an Austrian bank to facilitate clearing
operations.
(5) A mutual fund completely hedges its interest rate risk exposure by
using forward contingent contracts.
(6) A bond dealer uses his own equity to buy Mexican debt on the less
developed country (LDC) bond market.
(7) A securities firm sells a package of mortgage loans as mortgage-backed
securities.
37. Consider these four types of risks: credit, foreign exchange, market, and sovereign. These risks can be separated into two pairs of risk types in which each
pair consists of two related risk types, with one being a subset of the other.
How would you pair off the risk types, and which risk type could be considered a subset of the other type in the pair?
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8. Interest Rate Risk I 196
9. Interest Rate Risk II 226
10. Credit Risk: Individual Loan Risk 274
11. Credit Risk: Loan Portfolio and Concentration Risk 326
12. Liquidity Risk 351
13. Foreign Exchange Risk 383
14. Sovereign Risk 412
15. Market Risk 438
16. Off-Balance-Sheet Risk 474
17. Technology and Other Operational Risks 503
Chapter Eight
See Appendices Online at www.mhhe.com/saunders8e
• Appendix 8A: The Maturity Model
Interest Rate Risk I
INTRODUCTION
net worth
The value of an FI
to its owners; this is
equal to the difference
between the market
value of assets and
that of liabilities.
www.federalreserve.gov
www.bis.org
196
In Chapter 7 we established that while performing their asset-transformation
functions, FIs often mismatch the maturities of their assets and liabilities. In so
doing, they expose themselves to interest rate risk. For example, in the 1980s a
large number of thrifts suffered economic insolvency (i.e., the net worth or equity
of their owners was eradicated) when interest rates unexpectedly increased. All
FIs tend to mismatch their balance sheet maturities to some degree. However,
measuring interest rate risk exposure by looking only at the size of the maturity
mismatch can be misleading. The next two chapters present techniques used by
FIs to measure their interest rate risk exposures.
This chapter begins with a discussion of the Federal Reserve’s monetary policy,
which is a key determinant of interest rate risk. As we discuss later, in 2008–2014,
the Fed, in an effort to address the severe financial crisis and the slowly improving economy afterward, dropped its target fed funds rate to a range between zero
and a quarter of 1 percent and lowered its discount window rate to half a percent.
Thus, at this time interest rate risk at FIs may be relatively low. However, as the
economy recovers and/or inflation arises, interest rate risk will again become a
significant risk for FIs to manage.
The chapter also analyzes the simpler method used to measure an FI’s interest
rate risk: the repricing model. The repricing, or funding gap, model concentrates
on the impact of interest rate changes on an FI’s net interest income (NII), which
is the difference between an FI’s interest income and interest expense. Because
of its simplicity, smaller depository institutions (the vast majority of DIs) still
use this model as their primary measure of interest rate risk. Until recently,
U.S. bank regulators had been content to base their evaluations of bank interest
rate risk exposures on the repricing model. As explained later in this chapter,
however, the repricing model has some serious weaknesses. Appendix 8A, at
the book’s website (www.mhhe.com/saunders8e), compares and contrasts this
model with the market value–based maturity model. While rarely used anymore
by FIs, the maturity model was a first attempt to include the impact of interest
rate changes on the overall market value of an FI’s assets and liabilities and, ultimately, its net worth. In the early 2000s, the Bank for International Settlements
Chapter 8
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Interest Rate Risk I
197
(the organization of the world’s major Central Banks) issued a consultative document1 suggesting a standardized model be used by regulators in evaluating a
bank’s interest rate risk exposure. The approach suggested is firmly based on
market value accounting and the duration model (see Chapter 9). As regulators
move to adopt these models, bigger banks (which hold the vast majority of total
assets in the banking industry) have adopted them as their primary measure of
interest rate risk. Moreover, where relevant, banks may be allowed to use their
own market-value-based models (see Chapter 15) to assess the interest rate risk
of the banking book.
Appendix 8B, at the end of this chapter, looks at the term structure of interest
rates that compares the market yields or interest rates on securities, assuming that
all characteristics except maturity are the same. This topic is generally covered in
introductory finance courses. For students needing a review, Appendix 8B is encouraged introductory reading.
THE LEVEL AND MOVEMENT OF INTEREST RATES
www.federalreserve.gov
While many factors influence the level and movement of interest rates, it is the
central bank’s monetary policy strategy that most directly underlies the level and
movement of interest rates that, in turn, affect an FI’s cost of funds and return
on assets. The central bank in the United States is the Federal Reserve (the Fed).
Through its daily open market operations, such as buying and selling Treasury
bonds and Treasury bills, the Fed seeks to influence the money supply, inflation,
and the level of interest rates (particularly short-term interest rates). In turn,
changing interest rates impact economic decisions, such as whether to consume
or save. When the Fed finds it necessary to slow down the economy, it tightens
monetary policy by raising interest rates. The normal result is a decrease in business and household spending (especially that financed by credit or borrowing).
Conversely, if business and household spending declines to the extent that the
Fed finds it necessary to stimulate the economy, it allows interest rates to fall
(an expansionary monetary policy). The drop in rates promotes borrowing and
spending. For example, in December 2008, as the U.S. economy fell into its deepest
depression since the Great Depression, the Fed, in a historic move, unexpectedly
announced that it would drop its target fed funds rate to a range between zero and
a quarter of one percent and lower its discount window rate to a half a percent, the
lowest level since the 1940s. Even through January 2012, because of the economy’s
continued weakness, the Fed announced that it expected to keep fed fund rates
below 1 percent until late 2014. Figure 8–1 shows the interest rate on U.S. threemonth T-bills for the period 1965–2012. While Federal Reserve actions are targeted
mostly at short-term rates (especially the federal funds rate), changes in shortterm rates usually feed through to the whole term structure of interest rates. The
linkages between short-term rates and long-term rates and theories of the term
structure of interest rates are discussed in Appendix 8B to this chapter.
1
See Basel Committee on Banking Supervision, “Principles for the Management and Supervision of Interest Rate Risk,” Bank for International Settlements, Basel, Switzerland, January 2001.
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FIGURE 8–1 Interest Rate on U.S. 91-Day Treasury Bills, 1965–2012
Source: Federal Reserve Board website, various dates. www.federalreserve.gov
Interest rate
(%)
17
T-bill
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
Internet Exercise
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0
Year
Go to the Federal Reserve Board’s website at www.federalreserve.gov to find the latest
information available on three-month Treasury bill rates using the following steps. Click on
“Economic Research and Data.” Click on “Selected Interest Rates—H.15.” Click on “Current
Release.” This will download the data onto your computer that will contain the most recent
information on Treasury bill rates.
In addition to the Fed’s impact on interest rates via its monetary policy strategy, the increased level of financial market integration over the last decade has
also affected interest rates. Financial market integration increases the speed with
which interest rate changes and associated volatility are transmitted among countries, making the control of U.S. interest rates by the Federal Reserve more difficult
and less certain than before. The increased globalization of financial market flows
in recent years has made the measurement and management of interest rate risk
a prominent concern facing many modern FI managers. For example, investors
across the world carefully evaluate the statements made by Ben Bernanke (chairman of the Federal Reserve Board of Governors) before Congress. Even hints of
Chapter 8
Interest Rate Risk I
199
changes in U.S. interest rates may have a major effect on world interest rates (as
well as foreign exchange rates and stock prices).
The level and volatility of interest rates and the increase in worldwide financial market integration make the measurement and management of interest rate
risk one of the key issues facing FI managers. Further, the Bank for International
Settlements requires depository institutions (DIs) to have interest rate risk measurement systems that assess the effects of interest rate changes on both earnings
and economic value. These systems should provide meaningful measures of a
DI’s current levels of interest rate risk exposure and should be capable of identifying any excessive exposures that might arise (see Chapter 20). In this chapter and
in Chapter 9, we analyze the different ways an FI might measure the exposure it
faces in running a mismatched maturity book (or gap) between its assets and its
liabilities in a world of interest rate volatility.
In particular, we concentrate on three ways, or models, of measuring the asset–
liability gap exposure of an FI:
The repricing (or funding gap) model (in Chapter 8).
The maturity model (in Appendix 8A at www.mhhe.com/saunders8e).
The duration model (in Chapter 9).
Concept
Questions
1. How is the Federal Reserve’s monetary policy linked to the degree of interest rate
uncertainty faced by FIs?
2. How has financial market integration affected interest rate movements?
THE REPRICING MODEL
repricing gap
The difference
between assets whose
interest rates will be
repriced or changed
over some future
period (rate-sensitive
assets) and liabilities
whose interest rates
will be repriced or
changed over some
future period (ratesensitive liabilities).
The repricing, or funding gap, model is a simple model used by small (thus most)
FIs in the United States. This model is essentially a book value accounting cash
flow analysis of the repricing gap between the interest income earned on an FI’s
assets and the interest expense paid on its liabilities (or its net interest income) over
a particular period of time. This contrasts with the market value–based maturity
and duration models discussed in the appendix to this chapter and in Chapter 9.
Under the repricing gap approach, commercial banks report quarterly on their
call reports, interest-rate sensitivity reports which show the repricing gaps for
assets and liabilities with various maturities: For example,
rate-sensitive asset
or liability
1.
2.
3.
4.
5.
6.
One day.
More than one day to three months.
More than three months to six months.
More than six months to twelve months.
More than one year to five years.
More than five years.
An asset or liability
that is repriced at or
near current market
interest rates within a
maturity bucket.
A bank reports the gaps in each maturity bucket by calculating the rate sensitivity
of each asset (RSA) and each liability (RSL) on its balance sheet. Rate sensitivity
here means that the asset or liability is repriced at or near current market interest rates within a certain time horizon (or maturity bucket). Repricing can be the
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TABLE 8–1
Repricing Gap (in
millions of dollars)
1. One day
2. More than one day–three months
3. More than three months–six months
4. More than six months–twelve months
5. More than one year–five years
6. Over five years
refinancing risk
The risk that the cost
of rolling over or reborrowing funds will
rise above the returns
being earned on asset
investments.
reinvestment risk
The risk that the
returns on funds to
be reinvested will fall
below the cost of the
funds.
(1)
(2)
(3)
Assets
Liabilities
Gaps
(4)
Cumulative
Gap
$ 20
30
70
90
40
10
$260
$ 30
40
85
70
30
5
$260
$10
10
15
20
10
5
$10
20
35
15
5
0
result of a rollover of an asset or liability (e.g., a loan is paid off at or prior to maturity and the funds are used to issue a new loan at current market rates), or it can
occur because the asset or liability is a variable-rate instrument (e.g., a variable-rate
mortgage whose interest rate is reset every quarter based on movements in a prime
rate). Table 8–1 presents a simple interest rate sensitivity report showing the asset
and liability repricing gaps of an FI, categorized into each of the six previously
defined maturity buckets.
The advantage of the repricing model lies in its information value and its simplicity in pointing to an FI’s net interest income exposure (or profit exposure) to interest rate changes in different maturity buckets. For example, suppose that an FI has
a negative $10 million difference between its assets and liabilities being repriced
in one day (one-day bucket). Assets and liabilities that are repriced each day
are likely to be interbank borrowings on the federal funds or repurchase agreement market (see Chapter 2). Thus, a negative gap (RSA RSL) exposes the FI to
refinancing risk, in that a rise in these short-term rates would lower the FI’s net
interest income since the FI has more rate-sensitive liabilities than assets in this
bucket. In other words, assuming equal changes in interest rates on RSAs and
RSLs, interest expense will increase by more than interest revenue. Conversely, if
the FI has a positive $20 million difference between its assets and liabilities being
repriced in 6 months to 12 months, it has a positive gap (RSA RSL) for this
period and is exposed to reinvestment risk, in that a drop in rates over this period
would lower the FI’s net interest income; that is, interest income will decrease by
more than interest expense. Specifically, let:
NII i = Change in net interest income in maturity bucket i
GAPi = Dollar size of the gap between the book value of rate-sensitive assets
and rate-sensitive liabilities in maturity bucket i
Ri = Change in the level of interest rates impacting assets and liabilities in
the ith bucket
Then:
NII i (GAPi ) Ri (RSAi RSLi ) Ri
In this first bucket, if the gap is negative $10 million and short-term interest
rates (such as fed fund and/or repo rates) rise 1 percent, the annualized change in
the FI’s future net interest income is:
NII i ($10 million) 0.01 $100, 000
Chapter 8
Interest Rate Risk I
201
That is, the negative gap and associated refinancing risk results in a loss of $100,000
in net interest income for the FI.
This approach is very simple and intuitive. Remember, however, from Chapter 7
and our overview of interest rate risk that capital or market value losses also occur
when rates rise. The capital loss effect that is measured by both the maturity and
duration models developed in Appendix A to this chapter and in Chapter 9 is not
accounted for in the repricing model. The reason is that in the book value accounting world of the repricing model, asset and liability values are reported at their historic values or costs. Thus, interest rate changes affect only current interest income or
interest expense—that is, net interest income on the FI’s income statement—rather
than the market value of assets and liabilities on the balance sheet.2
The FI manager can also estimate cumulative gaps (CGAPs) over various
repricing categories or buckets. A common cumulative gap of interest is the oneyear repricing gap estimated from Table 8–1 as:
CGAP ($10) ($10) ($15) $20 $15 million
If ΔRi is the average interest rate change affecting assets and liabilities that can be
repriced within a year, the cumulative effect on the bank’s net interest income is:3
NII i (CGAP) Ri
($15 million) (0.01) $150, 000
(1)
We can now look at how an FI manager would calculate the cumulative oneyear gap from a balance sheet. Remember that the manager asks: Will or can this
asset or liability have its interest rate changed within the next year? If the answer is
yes, it is a rate-sensitive asset or liability. If the answer is no, it is not rate sensitive.
Consider the simplified balance sheet facing the FI manager in Table 8–2.
Instead of the original maturities, the maturities are those remaining on different
assets and liabilities at the time the repricing gap is estimated.
Rate-Sensitive Assets
Looking down the asset side of the balance sheet in Table 8–2, we see the following one-year rate-sensitive assets (RSAs):
1. Short-term consumer loans: $50 million. These are repriced at the end of the year
and just make the one-year cutoff.
2. Three-month T-bills: $30 million. These are repriced on maturity (rollover) every
three months.
3. Six-month T-notes: $35 million. These are repriced on maturity (rollover) every
six months.
4. 30-year floating-rate mortgages: $40 million. These are repriced (i.e., the mortgage
rate is reset) every nine months. Thus, these long-term assets are rate-sensitive
assets in the context of the repricing model with a one-year repricing horizon.
2
For example, a 30-year bond purchased 10 years ago when rates were 13 percent would be reported
as having the same book (accounting) value as when rates are 7 percent. Using market value, gains and
losses to asset and liability values would be reflected in the balance sheet as rates change.
3
Note that a change in the dollar value and mix of rate-sensitive assets and liabilities (or a change in
CGAP) also affects the FI’s net income.
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TABLE 8–2
Assets
Simple FI Balance
Sheet (in millions
of dollars)
1. Short-term consumer loans
(one-year maturity)
2. Long-term consumer loans
(two-year maturity)
3. Three-month Treasury bills
4. Six-month Treasury notes
5. Three-year Treasury bonds
6. 10-year, fixed-rate mortgages
7. 30-year, floating-rate mortgages
(rate adjusted every nine months)
Liabilities
$ 50
1. Equity capital (fixed)
$ 20
25
2. Demand deposits
40
30
35
70
20
3. Passbook savings
4. Three-month CDs
5. Three-month bankers acceptances
6. Six-month commercial paper
7. One-year time deposits
30
40
20
60
20
40
8. Two-year time deposits
$270
40
$270
Summing these four items produces total one-year rate-sensitive assets (RSAs)
of $155 million. The remaining $115 million of assets are not rate sensitive over the
one-year repricing horizon—that is, a change in the level of interest rates will not
affect the size of the interest income generated by these assets over the next year.4
Although the $115 million in long-term consumer loans, 3-year Treasury bonds,
and 10-year, fixed-rate mortgages generate interest income, the size of income generated will not change over the next year, since the interest rates on these assets
are not expected to change (i.e., they are fixed over the next year).
Rate-Sensitive Liabilities
Looking down the liability side of the balance sheet in Table 8–2, we see the following liability items clearly fit the one-year rate or repricing sensitivity test:
1. Three-month CDs: $40 million. These mature in three months and are repriced on
rollover.
2. Three-month bankers acceptances: $20 million. These also mature in three months
and are repriced on rollover.
3. Six-month commercial paper: $60 million. These mature and are repriced every six
months.
4. One-year time deposits: $20 million. These get repriced right at the end of the oneyear gap horizon.
Summing these four items produces one-year rate-sensitive liabilities (RSLs)
of $140 million. The remaining $130 million is not rate sensitive over the one-year
period. The $20 million in equity capital and $40 million in demand deposits (see
the following discussion) do not pay interest and are therefore classified as noninterest-paying. The $30 million in passbook savings (see the following discussion) and $40 million in two-year time deposits generate interest expense over
the next year, but the level of the interest expense generated will not change if
the general level of interest rates changes. Thus, we classify these items as rateinsensitive liabilities.
4
We are assuming that the assets are noncallable over the year and that there will be no prepayments
(runoffs, see below) on the mortgages within a year.
Chapter 8
Interest Rate Risk I
203
Note that demand deposits (or transaction accounts in general) are not included
as RSLs. We can make strong arguments for and against their inclusion as ratesensitive liabilities.
Against Inclusion
core deposits
Those deposits that
act as an FI’s longterm sources of funds.
The explicit interest rate on demand deposits is zero by regulation. Further,
although explicit interest is paid on transaction accounts such as NOW accounts,
the rates paid by FIs do not fluctuate directly with changes in the general level
of interest rates (particularly when the general level of rates is rising). Moreover,
many demand deposits act as core deposits for FIs, meaning they are a long-term
source of funds.
For Inclusion
Even though they pay no explicit interest, demand deposits pay implicit interest
because FIs do not charge fees that fully cover their costs for checking services.
Further, if interest rates rise, individuals draw down (or run off) their demand
deposits, forcing the bank to replace them with higher yielding, interest bearing,
rate-sensitive funds. This is most likely to occur when the interest rates on alternative instruments are high. In such an environment, the opportunity cost of holding
funds in demand deposit accounts is likely to be larger than it is in a low–interest
rate environment.
Similar arguments for and against inclusion of retail passbook savings accounts
can be made. Although Federal Reserve Regulation Q ceilings on the maximum rates
to be charged for these accounts were abolished in March 1986, banks still adjust
these rates only infrequently. However, savers tend to withdraw funds from these
accounts when rates rise, forcing banks into more expensive fund substitutions.5
The four repriced liabilities ($40 $20 $60 $20) sum to $140 million, and the
four repriced assets ($50 $30 $35 $40) sum to $155 million. Given this, the
cumulative one-year repricing gap (CGAP) for the bank is:
CGAP One-year rate-sensitive assets One-year rate-sensitive liabilities
RSA RSL
$155 million $140 million $15 million
Often FIs express interest rate sensitivity as a percentage of assets (A):
CGAP
$15 million
0.056 5.6%
A
$270 million
Expressing the repricing gap in this way is useful since it tells us (1) the direction
of the interest rate risk exposure (positive or negative CGAP) and (2) the scale
of that exposure as indicated by dividing the gap by the asset size of the institution. In our example the FI has 5.6 percent more RSAs than RSLs in one-year-andless buckets as a percentage of total assets. Alternatively, FIs calculate a gap ratio
defined as rate-sensitive assets divided by rate-sensitive liabilities. A gap ratio
5
The Federal Reserve’s repricing report has traditionally viewed transaction accounts and passbook savings accounts as rate-insensitive liabilities, as we have done in this example. However, with the growth
of the Internet and competition from money market mutual funds, the mobility of these funds is highly
sensitive to (relative) rates paid by banks versus other nonbank FIs (such as money market mutual funds).
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greater than 1 indicates that there are more rate sensitive assets than liabilities
(similar to a gap 0). Thus, the FI is set to see increases in net interest income when
interest rates increase. A gap ratio less than 1 indicates that there are more rate sensitive liabilities than assets (similar to a gap 0). Thus, the FI is set to see increases
in net interest income when interest rates decrease. In our example, the gap ratio
is 1.107 meaning that in the one-year-and-less time bucket, the FI has $1.107 of
RSAs for every $1 of RSLs. Table 8–3 shows an interest rate sensitivity report for
Harleysville Savings Financial Corp. (headquartered in Harleysville, Pennsylvania)
for 2011. In this report, Harleysville reports the repricing gap for periods ranging
from one to five years.
The choice of time horizon used to measure interest rate risk is critical to managing this risk. An excessively long repricing period includes many securities that
are repriced at different times within the repricing period. That is, it overstates the
rate sensitivity of the balance sheet and leaves the FI exposed to interest rate risk.
For example, consider a bank that measures interest rate risk exposure over a oneyear time horizon only and has a repricing gap of $0 over the one year. However,
if the bank has $50 million more RSAs than RSLs that are repriced in the first six
months of the year and $50 million more liabilities than assets that are repriced
over the last six months, it would be exposed to changes in interest rates occurring
within the year. In its gap analysis, the bank would show a zero repricing gap for
the year [50 (50) 0]. But the bank’s assets and liabilities are mismatched
within the bucket, and therefore, the bank is exposed to interest rate risk. Clearly,
the shorter the range over which bucket gaps are calculated, the smaller is this
problem. Conversely, an excessively short repricing period omits consideration
of the interest rate risk exposure of assets and liabilities are that repriced in the
period immediately following the end of the repricing period. That is, it understates the rate sensitivity of the balance sheet.
Equal Changes in Rates on RSAs and RSLs
The CGAP provides a measure of an FI’s interest rate sensitivity. Table 8–4 highlights the relation between CGAP and changes in NII when interest rate changes
for RSAs are equal to interest rate changes for RSLs. For example, when CGAP is
positive (or the FI has more RSAs than RSLs), NII will rise when interest rates rise
(row 1, Table 8–4), since interest income increases more than interest expense does.
EXAMPLE 8–1
Impact of Rate
Changes on Net
Interest Income
When CGAP Is
Positive
Suppose that, for the FI depicted in Table 8–2, interest rates rise by 1 percent on both RSAs
and RSLs. The CGAP would project the expected annual change in net interest income (∆NII)
of the FI as:
NII (RSA R ) (RSL R ) CGAP R
($155 million 0.01) ($140 million 0.01) ($15 million) 0.01
($1.55 million $1.40 million) $150,000
Similarly, if interest rates fall equally for RSAs and RSLs (row 2, Table 8–4), NII will fall when
CGAP is positive. As rates fall, interest income falls by more than interest expense. Thus, NII
falls. Suppose that for our FI, rates fall by 1 percent. The CGAP predicts that NII will fall by:
NII ($155 million ( 0.01)) ($140 million ( 0.01)) $15 million 0.01
$1.55 million ($1.40 million) $150,000
Chapter 8
TABLE 8–3
Interest Rate Risk I
205
Harleysville Savings Financial Corp., Interest Rate Sensitivity Report, 2011
Source: Harleysville Savings Financial, Form 10-K, 2011.
1 Year
or less
1 to 3
Years
3 to 5
Years
Over 5
Years
Total
(In Thousands)
Interest-earning assets:
Mortgage loans
Commercial loans
Mortgage-backed securities
Consumer and other loans
Investment securities and other investments
$ 56,557
49,658
55,908
68,042
80,462
$ 59,050
17,216
41,406
9,690
23,846
$ 46,569
14,329
23,289
4,552
21,445
$180,021
16,144
29,944
4,373
5,806
$342,197
97,347
150,547
86,657
131,559
Total interest-earning assets
310,627
151,208
110,184
236,288
808,307
Interest-bearing liabilities:
Passbook and Club accounts
NOW and interest-bearing checking accounts
Consumer Money Market Deposit accounts
Business Money Market Deposit accounts
Certificate accounts
Borrowed money
401
6,931
53,172
17,563
126,177
57,708
—
—
—
—
124,560
59,253
—
—
—
—
44,713
26,389
3,793
62,379
58,021
5,855
—
106,844
4,194
69,310
111,193
23,418
295,450
250,194
236,892
753,759
Total interest-bearing liabilities
261,952
183,813
71,102
Repricing GAP during the period
$ 48,675
$(32,605)
$ 39,082
$
Cumulative GAP
(604) $ 54,548
$ 48,675
$ 16,070
$ 55,152
$ 54,548
Ratio of GAP during the period to total assets
5.82%
3.90%
4.68%
0.07%
Ratio of cumulative GAP to total assets
5.82%
1.92%
6.60%
6.53%
CGAP effects
The relations between
changes in interest
rates and changes in
net interest income.
It is evident from this equation that the larger the absolute value of CGAP, the
larger the expected change in NII (i.e., the larger the increase or decrease in the
FI’s interest income relative to interest expense). In general, when CGAP is positive, the change in NII is positively related to the change in interest rates. Thus,
an FI would want its CGAP to be positive when interest rates are expected to rise.
Conversely, when CGAP is negative, if interest rates rise by equal amounts for
RSAs and RSLs (row 3, Table 8–4), NII will fall (since the FI has more RSLs than
RSAs). If interest rates fall equally for RSAs and RSLs (row 4, Table 8–4), NII will
increase when CGAP is negative. As rates fall, interest expense decreases by more
than interest income. In general then, when CGAP is negative, the change in NII
is negatively related to the change in interest rates. Thus, an FI would want its
CGAP to be negative when interest rates are expected to fall. We refer to these
relationships as CGAP effects.
Unequal Changes in Rates on RSAs and RSLs
The previous section considered changes in net interest income as interest rates
changed, assuming that the change in rates on RSAs was exactly equal to the change
in rates on RSLs (in other words, assuming the interest rate spread between rates on
RSAs and RSLs remained unchanged). This is not often the case. Rather, rate changes
on RSAs generally differ from those on RSLs (i.e., the spread between interest rates
on assets and liabilities change along with the levels of these rates). See Figure 8–2,
206
Part Two
Measuring Risk
TABLE 8–4
Impact of CGAP on
the Relation between
Changes in Interest
Rates and Changes
in Net Interest
Income, Assuming
Rate Changes for
RSAs Equal Rate
Changes and RSLs
spread effect
The effect that a
change in the spread
between rates on
RSAs and RSLs has
on net interest income
as interest rates
change.
EXAMPLE 8–2
Impact of Spread
Effect on Net
Interest Income
Row
CGAP
Change in
Interest
Rates
Change in
Interest
Income
Change in
Interest
Expense
Change in
NII
1
2
0
0
⇑
⇓
⇑
⇓
⇑
⇓
⇑
⇓
3
4
0
0
⇑
⇓
⇑
⇓
⇑
⇓
⇓
⇑
which plots quarterly CD rates (liabilities) and prime lending rates (assets) for the
period 1990–2012. Notice that although the rates generally move in the same direction, they are not perfectly correlated. In this case, as we consider the impact of rate
changes on NII, we have a spread effect in addition to the CGAP effect.
If the spread between the rate on RSAs and RSLs increases, when interest
rates rise (fall), interest income increases (decreases) by more (less) than interest
expense. The result is an increase in NII. Conversely, if the spread between the
rates on RSAs and RSLs decreases, when interest rates rise (fall), interest income
increases (decreases) less (more) than interest expense, and NII decreases. In general, the spread effect is such that, regardless of the direction of the change in
interest rates, a positive relation exists between changes in the spread (between
rates on RSAs and RSLs) and changes in NII. Whenever the spread increases
(decreases), NII increases (decreases).
To understand spread effect, assume for a moment that RSAs equal RSLs equal $155 million.
Suppose that rates rise by 1.2 percent on RSAs and by 1 percent on RSLs (i.e., the spread
between the rates on RSAs and RSLs increases by 1.2 percent 1 percent 0.2 percent). The
resulting change in NII is calculated as:
NII (RSA RRSA ) (RSL RRSL )
Interest revenue Interest expense
($155 million 1.2%) ($155 million 1.0%)
$155 million (1.2% 1.0%)
$310,000
(2)
See Table 8–5 for various combinations of CGAP and spread changes and their
effects on NII. The first four rows in Table 8–5 consider an FI with a positive CGAP;
the last four rows consider an FI with a negative CGAP. Notice in Table 8–5 that both
the CGAP and spread effects can have the same effect on NII. For example, in row 6 of
Table 8–5, if CGAP is negative and interest rates increase, the CGAP effect says NII will
decrease. If, at the same time, the spread between RSAs and RSLs decreases as interest
rates increase, the spread effect also says NII will decrease. In these cases, FI managers
can accurately predict the direction of the change in NII as interest rates change. When
the two work in opposite directions, however, the change in NII cannot be predicted
without knowing the size of the CGAP and expected change in the spread. For example, in row 5 of Table 8–5, if CGAP is negative and interest rates increase, the CGAP
effect says NII will decrease. If, at the same time, the spread between RSAs and RSLs
increases as interest rates increase, the spread effect says NII will increase.
Chapter 8
FIGURE 8–2
Yield (%)
Three-Month CD
Rates versus Prime
Rates for 1990–2012
12
Source: Federal Reserve
Bulletin, various issues.
www.federalreserve.gov
Interest Rate Risk I
207
Prime (RSA)
CD (RSL)
10
8
6
4
2
Impact of CGAP
on the Relation
between Changes
in Interest Rates
and Changes
in Net Interest
Income, Allowing
for Different Rate
Changes for RSAs
and RSLs
EXAMPLE 8–3
Combined
Impact of CGAP
and Spread Effect
on Net Interest
Income
-1
2
Year
Ja
n
8
-1
0
Ja
n
-0
6
Ja
n
Ja
n
-0
-0
4
2
Ja
n
0
-0
Ja
n
8
-0
Ja
n
-9
6
TABLE 8–5
Ja
n
4
-9
Ja
n
2
-9
Ja
n
-9
Ja
n
Ja
n
-9
0
0
Change in
Interest Rates
Change in
Spread
NII
0
0
0
0
⇑
⇑
⇓
⇓
⇑
⇓
⇑
⇓
⇑
⇑⇓
⇑⇓
⇓
0
0
0
0
⇑
⇑
⇓
⇓
⇑
⇓
⇑
⇓
⇑⇓
⇓
⇑
⇑⇓
Row
CGAP
1
2
3
4
5
6
7
8
Suppose that for the FI in Table 8–2, interest rates fall by 1 percent on RSAs and by
1.2 percent on RSLs. Now the change in NII is calculated as:
NII [$155 million (0.01)] [$140 million (0.012)]
$1.55 million ($1.68 million)
$0.13 million or $130,000
Even though the CGAP effect (i.e., RSA RSL) is putting negative pressure on NII (in Example
8–1, the CGAP effect of a 1 percent decrease in the rate on both RSAs and RSLs produced a
decrease in NII of $150,000), the increase in the spread, and the resulting spread effect, is so
big that NII increases by $130,000.
Some FIs accept quite large interest rate exposures relative to their asset sizes.
For example, the one-year repricing gap to total assets ratio of Harleysville Savings Financial Corporation (Harleysville, Pennsylvania) was 5.82 percent at the
end of 2011 and the five-year gap to total assets ratio was 6.60 percent (i.e., it had
more RSAs than RSLs). If interest rates rose in 2012, Harleysville Savings was set
up to see net interest income increases due to the repricing of its large amount of
208
Part Two
Measuring Risk
RSAs (relative to RSLs) at higher rates. Thus, Harleysville’s management set its
balance sheet up in expectation of interest rate increases over the next five years.
Conversely, HopFed Bancorp (headquartered in Hopkinsville, Kentucky) reported
a one-year repricing gap to total assets ratio of 5.69 percent and a five-year ratio
of 6.98 percent. Thus, HopFed was set up to see net interest income increases
at lower interest rates. That is, HopFed’s management set its balance sheet up in
expectation of interest rate decreases over the next five years.
The repricing gap is the measure of interest rate risk historically used by FIs,
and it is still the main measure of interest rate risk used by small community banks
and thrifts. In contrast to the market value–based models of interest rate risk discussed in Appendix A to this chapter and in Chapter 9, the repricing gap model
is conceptually easy to understand and can easily be used to forecast changes in
profitability for a given change in interest rates. The repricing gap can be used to
allow an FI to structure its assets and liabilities or to go off the balance sheet to take
advantage of a projected interest rate change. However, the repricing gap model
has some major weaknesses that have resulted in regulators’ calling for the use of
more comprehensive models (e.g., the duration gap model) to measure interest
rate risk. We next discuss some of the major weaknesses of the repricing model.
Concept
Questions
1. Summarize the case for and against the inclusion of demand deposits as a ratesensitive liability.
2. How can FIs change the size and the direction of their repricing gap?
3. Why is it useful to express the repricing gap in terms of a percentage of assets? What
specific information does this provide?
WEAKNESSES OF THE REPRICING MODEL
Despite the fact that this model of interest rate risk is used by the vast majority of
depository institutions in the United States, the repricing model has four major
shortcomings: (1) It ignores market value effects of interest rate changes, (2) it is
overaggregative, (3) it fails to deal with the problem of rate-insensitive asset and
liability runoffs and prepayments, and (4) it ignores cash flows from off-balancesheet activities. In this section we discuss each of these weaknesses in more detail.
Market Value Effects
As was discussed in the overview of FI risks (Chapter 7), interest rate changes
have a market value effect in addition to an income effect on asset and liability values. That is, the present values of the cash flows on assets and liabilities
change, in addition to the immediate interest received or paid on them, as interest
rates change. In fact, the present values (and where relevant, the market prices) of
virtually all assets and liabilities on an FI’s balance sheet change as interest rates
change. The repricing model ignores the market value effect—implicitly assuming a book value accounting approach. As such, the repricing gap is only a partial
measure of the true interest rate risk exposure of an FI. As we discuss the market
value–based measures of interest rate risk (in Appendix A and in Chapter 9), we
highlight the impact that ignoring the market value effect has on the ability to
accurately measure the overall interest rate risk of an FI.
Chapter 8
Interest Rate Risk I
209
Overaggregation
The problem of defining buckets over a range of maturities ignores information
regarding the distribution of assets and liabilities within those buckets. For example, the dollar values of RSAs and RSLs within any maturity bucket range may
be equal. However, on average, liabilities may be repriced toward the end of the
bucket’s range, while assets may be repriced toward the beginning, in which case
a change in interest rates will have an effect on asset and liability cash flows that
will not be accurately measured by the repricing gap approach.
Look at the simple example for the three-month to six-month bucket in Figure 8–3.
Note that $50 million more RSAs than RSLs are repriced between months 3 and 4,
while $50 million more RSLs than RSAs are repriced between months 5 and 6. The
FI in its interest rate sensitivity report would show a zero repricing gap for the threemonth to six-month bucket [50 (50) 0]. But as you can easily see, the FI’s
assets and liabilities are mismatched within the bucket. Clearly, the shorter the range
over which bucket gaps are calculated, the smaller this problem is. If an FI manager
calculated one-day bucket gaps out into the future, this would give a more accurate picture of the net interest income exposure to rate changes. Reportedly, many
large FIs have internal systems that indicate their repricing gaps on any given day in
the future (252 days’ time, 1,329 days’ time, etc.). This suggests that although regulators examine the reporting of repricing gaps over only relatively wide maturity
bucket ranges, FI managers could set in place internal information systems to report
the daily future patterns of such gaps.
The Problem of Runoffs
In the simple repricing model discussed earlier, we assumed that all consumer
loans matured in 1 year or that all conventional mortgages matured in 30 years. In
reality, the FI continuously originates and retires consumer and mortgage loans as
it creates and retires deposits. For example, today, some 30-year original maturity
mortgages may have only 1 year left before they mature; that is, they are in their
29th year. In addition, these loans may be listed as 30-year mortgages (and included
as not rate sensitive), yet they will sometimes be prepaid early as mortgage holders
refinance their mortgages and/or sell their houses. Thus, the resulting proceeds
will be reinvested at current market rates within the year. In addition, even if an
FIGURE 8–3
The
Overaggregation
Problem: The
Three-Month to SixMonth Bucket
RSA-RSL
150
0
1
250
RSA-RSL
2
3
4
5
6
7
8
9
10 Months
210
Part Two
Measuring Risk
runoff
Periodic cash flow of
interest and principal
amortization payments on long-term
assets, such as conventional mortgages,
that can be reinvested
at market rates.
asset or liability is rate insensitive, virtually all assets and liabilities (e.g., long-term
mortgages) pay some principal and/or interest back to the FI in any given year. As
a result, the FI receives a runoff cash flow from its rate-insensitive portfolio that
can be reinvested at current market rates. That is, this runoff cash flow component
of a rate-insensitive asset or liability is itself rate sensitive. The FI manager can deal
easily with this in the repricing model by identifying for each asset and liability
item the estimated dollar cash flow that will run off within the next year and adding these amounts to the value of rate sensitive assets and liabilities.
Cash Flows from Off-Balance-Sheet Activities
The RSAs and RSLs used in the repricing model generally include only the assets
and liabilities listed on the balance sheet. Changes in interest rates will affect
the cash flows on many off-balance-sheet instruments as well. For example, an
FI might have hedged its interest rate risk with an interest rate futures contract
(see Chapter 22). As interest rates change, these futures contracts—as part of the
marking-to-market process—produce a daily cash flow (either positive or negative) for the FI that may offset any on-balance-sheet gap exposure. These offsetting
cash flows from futures contracts are ignored by the simple repricing model and
should (and could) be included in the model.
www.mhhe.com/saunders8e
Concept
Questions
1. What are four major weaknesses of the repricing model?
2. What does runoff mean?
Summary
This chapter introduced a method of measuring an FI’s interest rate risk exposure:
the repricing model. The repricing model looks at the difference, or gap, between
an FI’s rate-sensitive assets and rate-sensitive liabilities to measure interest rate risk.
The chapter showed that the repricing model has difficulty in accurately measuring
the interest rate risk of an FI. In particular, the repricing model ignores the market
value effects of interest rate changes. More complete and accurate measures of an FI’s
exposure are duration and the duration gap, which are explained in the next chapter.
Questions
and Problems
1. How do monetary policy actions made by the Federal Reserve impact interest rates?
2. How has the increased level of financial market integration affected interest rates?
3. What is the repricing gap? In using this model to evaluate interest rate risk,
what is meant by rate sensitivity? On what financial performance variable does
the repricing model focus? Explain.
4. What is a maturity bucket in the repricing model? Why is the length of time
selected for repricing assets and liabilities important in using the repricing model?
5. What is the CGAP effect? According to the CGAP effect, what is the relation
between changes in interest rates and changes in net interest income when
CGAP is positive? When CGAP is negative?
6. Which of the following is an appropriate change to make on a bank’s balance
sheet when GAP is negative, spread is expected to remain unchanged, and
interest rates are expected to rise?
a. Replace fixed-rate loans with rate-sensitive loans.
b. Replace marketable securities with fixed-rate loans.
Chapter 8
Interest Rate Risk I
211
c. Replace fixed-rate CDs with rate-sensitive CDs.
d. Replace equity with demand deposits.
e. Replace vault cash with marketable securities.
7. If a bank manager was quite certain that interest rates were going to rise
within the next six months, how should the bank manager adjust the bank’s
six-month repricing gap to take advantage of this anticipated rise? What if the
manager believed rates would fall in the next six months?
8. Consider the following balance sheet positions for a financial institution:
• Rate-sensitive assets $200 million
Rate-sensitive liabilities $100 million
• Rate-sensitive assets $100 million
Rate-sensitive liabilities $150 million
• Rate-sensitive assets $150 million
Rate-sensitive liabilities $140 million
a. Calculate the repricing gap and the impact on net interest income of a
1 percent increase in interest rates for each position.
b. Calculate the impact on net interest income of each of the above situations,
assuming a 1 percent decrease in interest rates.
c. What conclusion can you draw about the repricing model from these results?
9. Consider the following balance sheet for MMC Bancorp (in millions of
dollars):
1. Cash and due from
2. Short-term consumer loans
(one-year maturity)
3. Long-term consumer loans
(two-year maturity)
4. Three-month T-bills
5. Six-month T-notes
6. Three-year T-bonds
7. 10-year, fixed-rate mortgages
8. 30-year, floating-rate mortgages
9. Premises
Liabilities
$
6.25
62.50
31.25
37.50
43.75
75.00
25.00
50.00
6.25
$337.50
1. Equity capital (fixed)
$ 25.00
2. Demand deposits
50.00
3. Passbook savings
4. Three-month CDs
5. Three-month bankers’ acceptances
6. Six-month commercial paper
7. One-year time deposits
8. Two-year time deposits
37.50
50.00
25.00
75.00
25.00
50.00
$337.50
a. Calculate the value of MMC’s rate-sensitive assets, rate-sensitive liabilities,
and repricing gap over the next year.
b. Calculate the expected change in the net interest income for the bank if
interest rates rise by 1 percent on both RSAs and RSLs. If interest rates fall
by 1 percent on both RSAs and RSLs.
c. Calculate the expected change in the net interest income for the bank if
interest rates rise by 1.2 percent on RSAs and by 1 percent on RSLs. If interest rates fall by 1.2 percent on RSAs and by 1 percent on RSLs.
10. What are the reasons for not including demand deposits as rate-sensitive liabilities in the repricing analysis for a commercial bank? What is the subtle but
potentially strong reason for including demand deposits in the total of rate
sensitive liabilities? Can the same argument be made for passbook savings
accounts?
www.mhhe.com/saunders8e
Assets
212
Part Two
Measuring Risk
11. What is the gap to total assets ratio? What is the value of this ratio to interest
rate risk managers and regulators?
12. Which of the following assets or liabilities fit the one-year rate or repricing
sensitivity test?
3-month U.S. Treasury bills
1-year U.S. Treasury notes
20-year U.S. Treasury bonds
20-year floating-rate corporate bonds with annual repricing
30-year floating-rate mortgages with repricing every two years
30-year floating-rate mortgages with repricing every six months
Overnight fed funds
9-month fixed-rate CDs
1-year fixed-rate CDs
5-year floating-rate CDs with annual repricing
Common stock
13. What is the spread effect?
14. A bank manager is quite certain that interest rates are going to fall within the
next six months. How should the bank manager adjust the bank’s six-month
repricing gap and spread to take advantage of this anticipated rise? What if
the manager believes rates will rise in the next six months?
15. Consider the following balance sheet for WatchoverU Savings Inc. (in millions):
Assets
Floating-rate mortgages
(currently 10% annually)
30-year fixed-rate loans
(currently 7% annually)
www.mhhe.com/saunders8e
Total assets
Liabilities and Equity
$ 50
50
$100
1-year time deposits
(currently 6% annually)
3-year time deposits
(currently 7% annually)
Equity
Total liabilities and equity
$ 70
20
10
$100
a. What is WatchoverU’s expected net interest income at year-end?
b. What will net interest income be at year-end if interest rates rise 2 percent?
c. Using the cumulative repricing gap model, what is the expected net interest income for a 2 percent increase in interest rates?
d. What will net interest income be at year-end if interest rates on RSAs
increase by 2 percent but interest rates on RSLs increase by 1 percent? Is it
reasonable for changes in interest rates on RSAs and RSLs to differ? Why?
16. Use the following information about a hypothetical government security
dealer named M. P. Jorgan. Market yields are in parentheses, and amounts are
in millions.
Assets
Cash
1-month T-bills (7.05%)
3-month T-bills (7.25%)
2-year T-notes (7.50%)
8-year T-notes (8.96%)
5-year munis (floating rate)
(8.20% reset every 6 months)
Total assets
Liabilities and Equity
$ 10
75
75
50
100
Overnight repos
Subordinated debt
7-year fixed rate (8.55%)
$170
150
25
$335
Equity
Total liabilities and equity
15
$335
Chapter 8
Interest Rate Risk I
213
a. What is the repricing gap if the planning period is 30 days? 3 months?
2 years? Recall that cash is a non-interest-earning asset.
b. What is the impact over the next 30 days on net interest income if interest
rates increase 50 basis points? Decrease 75 basis points?
c. The following one-year runoffs are expected: $10 million for two-year
T-notes and $20 million for eight-year T-notes. What is the one-year repricing gap?
d. If runoffs are considered, what is the effect on net interest income at year
end if interest rates increase 50 basis points? Decrease 75 basis points?
17. A bank has the following balance sheet:
Assets
Rate sensitive
Fixed rate
Nonearning
Total
$ 550,000
755,000
265,000
$1,570,000
Avg. Rate
7.75%
8.75
Liabilities/Equity
Rate sensitive
Fixed rate
Nonpaying
Total
$ 375,000
805,000
390,000
$1,570,000
Avg. Rate
6.25%
7.50
Suppose interest rates rise such that the average yield on rate-sensitive assets
increases by 45 basis points and the average yield on rate-sensitive liabilities
increases by 35 basis points.
a. Calculate the bank’s CGAP, gap to total assets ratio, and gap ratio.
b. Assuming the bank does not change the composition of its balance sheet,
calculate the resulting change in the bank’s interest income, interest
expense, and net interest income.
c. Explain how the CGAP and spread effects influenced the change in net
interest income.
18. A bank has the following balance sheet:
Rate sensitive
Fixed rate
Nonearning
Total
$ 550,000
755,000
265,000
$1,570,000
Avg. Rate
7.75%
8.75
Liabilities/Equity
Rate sensitive
Fixed rate
Nonpaying
Total
$ 575,000
605,000
390,000
$1,570,000
Avg. Rate
6.25%
7.50
Suppose interest rates fall such that the average yield on rate-sensitive assets
decreases by 15 basis points and the average yield on rate-sensitive liabilities
decreases by 5 basis points.
a. Calculate the bank’s CGAP, gap to total assets ratio, and gap ratio.
b. Assuming the bank does not change the composition of its balance sheet,
calculate the resulting change in the bank’s interest income, interest
expense, and net interest income.
c. The bank’s CGAP is negative and interest rates decreased, yet net interest
income decreased. Explain how the CGAP and spread effects influenced
this decrease in net interest income.
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Assets
214
Part Two
Measuring Risk
19. The balance sheet of A. G. Fredwards, a government security dealer, is listed
below. Market yields are in parentheses, and amounts are in millions.
Assets
Cash
1-month T-bills (7.05%)
3-month T-bills (7.25%)
2-year T-notes (7.50%)
8-year T-notes (8.96%)
5-year munis (floating rate)
(8.20% reset every 6 months)
Total assets
Liabilities and Equity
$ 20
150
150
100
200
Overnight repos
Subordinated debt
7-year fixed rate (8.55%)
$340
50
$670
Equity
Total liabilities and equity
30
$670
300
a. What is the repricing gap if the planning period is 30 days? 3 months?
2 years?
b. What is the impact over the next three months on net interest income if
interest rates on RSAs increase 50 basis points and on RSLs increase 60
basis points?
c. What is the impact over the next two years on net interest income if interest rates on RSAs increase 50 basis points and on RSLs increase 75 basis
points?
d. Explain the difference in your answers to parts (b) and (c). Why is one
answer a negative change in NII, while the other is positive?
20. A bank has the following balance sheet:
Assets
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Rate sensitive
Fixed rate
Nonearning
Total
Avg. Rate
$225,000
550,000
120,000
$895,000
6.35%
7.55
Liabilities/Equity
Rate sensitive
Fixed rate
Nonpaying
Total
$300,000
505,000
90,000
$895,000
Avg. Rate
4.25%
6.15
Suppose interest rates rise such that the average yield on rate-sensitive assets
increases by 45 basis points and the average yield on rate-sensitive liabilities
increases by 35 basis points.
a. Calculate the bank’s repricing GAP.
b. Assuming the bank does not change the composition of its balance sheet,
calculate the net interest income for the bank before and after the interest
rate changes. What is the resulting change in net interest income?
c. Explain how the CGAP and spread effects influenced this increase in net
interest income.
21. What are some of the weaknesses of the repricing model? How have large
banks solved the problem of choosing the optimal time period for repricing?
What is runoff cash flow, and how does this amount affect the repricing model’s analysis?
The following questions and problems are based on material in Appendix 8A,
located on the website (www.mhhe.com/saunders8e).
22. What is a maturity gap? How can the maturity model be used to immunize an
FI’s portfolio? What is the critical requirement that allows maturity matching
to have some success in immunizing the balance sheet of an FI?
Chapter 8
Interest Rate Risk I
215
23. Nearby Bank has the following balance sheet (in millions):
Assets
Cash
5-year Treasury notes
30-year mortgages
Total assets
Liabilities and Equity
$ 60
60
200
$320
Demand deposits
1-year certificates of deposit
Equity
Total liabilities and equity
$140
160
20
$320
What is the maturity gap for Nearby Bank? Is Nearby Bank more exposed to
an increase or a decrease in interest rates? Explain why.
24. County Bank has the following market value balance sheet (in millions, all
interest at annual rates). All securities are selling at par equal to book value.
Liabilities and Equity
Cash
15-year commercial loan
at 10% interest,
balloon payment
30-year mortgages at
8% interest,
balloon payment
$ 20
Total assets
$480
160
300
Demand deposits
5-year CDs at
6% interest,
balloon payment
20-year debentures
at 7% interest, balloon
payment
Equity
Total liabilities and equity
$100
210
120
50
$480
a. What is the maturity gap for County Bank?
b. What will be the maturity gap if the interest rates on all assets and liabilities increase 1 percent?
c. What will happen to the market value of the equity?
25. If a bank manager is certain that interest rates are going to increase within the
next six months, how should the bank manager adjust the bank’s maturity gap
to take advantage of this anticipated increase? What if the manager believes rates
will fall? Would your suggested adjustments be difficult or easy to achieve?
26. An insurance company has invested in the following fixed-income securities:
(a) $10,000,000 of five-year Treasury notes paying 5 percent interest and selling at par value, (b) $5,800,000 of 10-year bonds paying 7 percent interest with
a par value of $6,000,000, and (c) $6,200,000 of 20-year subordinated debentures paying 9 percent interest with a par value of $6,000,000.
a. What is the weighted-average maturity of this portfolio of assets?
b. If interest rates change so that the yields on all the securities decrease
1 percent, how does the weighted-average maturity of the portfolio change?
c. Explain the changes in the maturity values if the yields increase 1 percent.
d. Assume that the insurance company has no other assets. What will be
the effect on the market value of the company’s equity if the interest rate
changes in (b) and (c) occur?
27. The following is a simplified FI balance sheet:
Assets
Liabilities and Equity
Loans
$1,000
Total assets
$1,000
Deposits
Equity
Total liabilities and equity
$ 850
150
$1,000
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Assets
216
Part Two
Measuring Risk
The average maturity of loans is four years and the average maturity of deposits is two years. Assume that loan and deposit balances are reported as book
value, zero-coupon items.
a. Assume that the interest rate on both loans and deposits is 9 percent. What
is the market value of equity?
b. What must be the interest rate on deposits to force the market value of
equity to be zero? What economic market conditions must exist to make
this situation possible?
c. Assume that the interest rate on both loans and deposits is 9 percent. What
must be the average maturity of deposits for the market value of equity to
be zero?
28. Gunnison Insurance has reported the following balance sheet (in thousands):
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Assets
Liabilities and Equity
2-year Treasury note
15-year munis
$175
165
Total assets
$340
1-year commercial paper
5-year note
Equity
Total liabilities and equity
$135
160
45
$340
All securities are selling at par equal to book value. The two-year notes are
yielding 5 percent, and the 15-year munis are yielding 9 percent. The one-year
commercial paper pays 4.5 percent, and the five-year notes pay 8 percent. All
instruments pay interest annually.
a. What is the weighted-average maturity of the assets for Gunnison?
b. What is the weighted-average maturity of the liabilities for Gunnison?
c. What is the maturity gap for Gunnison?
d. What does your answer to part (c) imply about the interest rate risk exposure of Gunnison Insurance?
e. Calculate the values of all four securities on Gunnison Insurance’s balance
sheet assuming that all interest rates increase 2 percent. What is the dollar
change in the total asset and total liability values? What is the percentage
change in these values?
f. What is the dollar impact on the market value of equity for Gunnison?
What is the percentage change in the value of the equity?
g. What would be the impact on Gunnison’s market value of equity if the
liabilities paid interest semiannually instead of annually?
29. Scandia Bank has issued a one-year, $1 million CD paying 5.75 percent to fund
a one-year loan paying an interest rate of 6 percent. The principal of the loan
will be paid in two installments: $500,000 in six months and the balance at the
end of the year.
a. What is the maturity gap of Scandia Bank? According to the maturity
model, what does this maturity gap imply about the interest rate risk exposure faced by Scandia Bank?
b. Assuming no change in interest rates over the year, what is the expected
net interest income at the end of the year?
c. What would be the effect on annual net interest income of a 2 percent interest rate increase that occurred immediately after the loan was made? What
would be the effect of a 2 percent decrease in rates?
d. What do these results indicate about the ability of the maturity model to
immunize portfolios against interest rate exposure?
Chapter 8
Interest Rate Risk I
217
30. EDF Bank has a very simple balance sheet. Assets consist of a two-year,
$1 million loan that pays an interest rate of LIBOR plus 4 percent annually.
The loan is funded with a two-year deposit on which the bank pays LIBOR
plus 3.5 percent interest annually. LIBOR currently is 4 percent, and both the
loan and the deposit principal will be paid at maturity.
a. What is the maturity gap of this balance sheet?
b. What is the expected net interest income in year 1 and year 2?
c. Immediately prior to the beginning of year 2, LIBOR rates increase to
6 percent. What is the expected net interest income in year 2? What would
be the effect on net interest income of a 2 percent decrease in LIBOR?
d. What do the answers to parts (b) and (c) of this question suggest about the
use of maturity gap to immunize an FI against interest rate risk?
31. What are the weaknesses of the maturity gap model?
The following questions and problems are based on material in Appendix 8B
to the chapter.
32. Suppose that the current one-year rate (one-year spot rate) and expected oneyear T-bill rates over the following three years (i.e., years 2, 3, and 4, respectively) are as follows:
33.
34.
35.
36.
37.
6% E(2 r1 ) 7%
E(3 r1 ) 7.5%
E( 4 r1 ) 7.85%
Using the unbiased expectations theory, calculate the current (long-term) rates
for one-, two-, three-, and four-year-maturity Treasury securities. Plot the resulting yield curve.
The current one-year Treasury bill rate is 5.2 percent, and the expected one-year
rate 12 months from now is 5.8 percent. According to the unbiased expectations theory, what should be the current rate for a two-year Treasury security?
The Wall Street Journal reported interest rates of 6 percent, 6.35 percent,
6.65 percent, and 6.75 percent for three-year, four-year, five-year, and six-year
Treasury notes, respectively. According to the unbiased expectations theory,
what are the expected one-year rates for years 4, 5, and 6?
The Wall Street Journal reports that the rate on three-year Treasury securities
is 5.60 percent and the rate on four-year Treasury securities is 5.65 percent.
According to the unbiased expectations hypothesis, what does the market
expect the one-year Treasury rate to be in year 4, E(4r1)?
How does the liquidity premium theory of the term structure of interest rates
differ from the unbiased expectations theory? In a normal economic environment, that is, an upward-sloping yield curve, what is the relationship of
liquidity premiums for successive years into the future? Why?
Based on economists’ forecasts and analysis, one-year Treasury bill rates and
liquidity premiums for the next four years are expected to be as follows:
1 R1
5.65%
E(2 r1 ) 6.75% L2 0.05%
E( 3 r1 ) 6.85% L3 0.10%
E( 4 r1 ) 7.15% L4 0.12%
Using the liquidity premium hypothesis, plot the current yield curve. Make
sure you label the axes on the graph and identify the four annual rates on the
curve both on the axes and on the yield curve itself.
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1 R1
218
Part Two
Measuring Risk
38. The Wall Street Journal reports that the rate on three-year Treasury securities is
5.25 percent and the rate on four-year Treasury securities is 5.50 percent. The
one-year interest rate expected in year four, E(4r1), is 6.10 percent. According
to the liquidity premium hypothesis, what is the liquidity premium on the
four-year Treasury security, L4?
39. You note the following yield curve in The Wall Street Journal. According to the
unbiased expectations hypothesis, what is the one-year forward rate for the
period beginning two years from today, 2 f1?
Maturity
Yield
One day
One year
Two years
Three years
2.00%
5.50
6.50
9.00
Integrated Mini Case
CALCULATING AND USING THE REPRICING GAP
State Bank’s balance sheet is listed below. Market yields are in parentheses, and amounts are in millions.
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Assets
Liabilities and Equity
Cash
Fed funds (5.05%)
3-month T-bills (5.25%)
2-year T-notes (6.50%)
8-year T-bonds (7.50%)
5-year munis (floating rate) (8.20%, repriced
@ 6 months)
6-month consumer loans (6%)
1-year consumer loans (5.8%)
5-year car loans (7%)
7-month C&I loans (5.8%)
2-year C&I loans (floating rate) (5.15%, repriced
@ 6 months)
15-year variable-rate mortgages (5.8%, repriced
@ 6 months)
15-year variable-rate mortgages (6.1%, repriced
@ year)
15-year fixed-rate mortgages (7.85%)
30-year variable-rate mortgages (6.3%, repriced
@ quarter)
30-year variable-rate mortgages (6.4%, repriced
@ month)
30-year fixed-rate mortgages (8.2%)
Premises and equipment
$
20
150
150
100
200
Total assets
$3,945
50
250
300
350
200
275
200
400
300
Demand deposits
Savings accounts (1.5%)
MMDAs (4.5%) (no minimum
balance requirement)
3-month CDs (4.2%)
6-month CDs (4.3%)
1-year CDs (4.5%)
2-year CDs (5%)
4-year CDs (5.5%)
5-year CDs (6%)
Fed funds (5%)
Overnight repos (5%)
6-month commercial paper (5.05%)
Subordinate notes:
3-year fixed rate (6.55%)
Subordinated debt:
7-year fixed rate (7.25%)
Total liabilities
$ 250
20
Equity
Total liabilities and equity
400
$3,945
340
120
220
375
425
330
350
225
290
300
200
100
$3,545
225
355
400
20
1. What is the repricing gap if the planning period
is 30 days? 6 months? 1 year? 2 years? 5 years?
2. What is the impact over the next six months
on net interest income if interest rates on RSAs
increase 60 basis points and on RSLs increase
40 basis points?
Interest Rate Risk I
219
3. What is the impact over the next year on
net interest income if interest rates on RSAs
increase 60 basis points and on RSLs increase
40 basis points?
Appendix 8A: The Maturity Model
View Appendix 8A at the website for this textbook (www.mhhe.com/saunders8e).
Appendix 8B
Term Structure of Interest Rates
To explain the process of estimating the impact
of an unexpected shock in short-term interest
rates on the entire term structure of interest rates,
FIs use the theory of the term structure of interest rates or the yield curve. The term structure of
interest rates compares the market yields or interest rates on securities, assuming that all characteristics (default risk, coupon rate, etc.) except
maturity are the same. The change in required
interest rates as the maturity of a security changes
is called the maturity premium (MP). The MP, or
the difference between the required yield on longand short-term securities of the same characteristics except maturity, can be positive, negative, or
zero. The yield curve for U.S. Treasury securities is
the most commonly reported and analyzed yield
curve. The shape of the yield curve on Treasury
securities has taken many forms over the years,
but the three most common shapes are shown
in Figure 8B–1. In graph (a), the yield curve on
May 29, 2012, yields rise steadily with maturity
when the yield curve is upward sloping. This
is the most common yield curve, so on average
the MP is positive. Graph (b) shows an inverted
or downward-sloping yield curve, reported on
November 24, 2000, for which yields decline as
maturity increases. Inverted yield curves do not
generally last very long. Finally, graph (c) shows a
flat yield curve, reported on June 4, 2007, in which
the yield to maturity is virtually unaffected by the
term to maturity.
Note that these yield curves may reflect factors
other than investors’ preferences for the maturity
of a security, since in reality there may be liquidity
differences among the securities traded at different points along the yield curve. For example,
newly issued 20-year Treasury bonds offer a rate
of return less than (seasoned issues) 10-year Treasury bonds if investors prefer new (“on the run”)
securities to previously issued (“off the run”) securities. Specifically, since the Treasury (historically)
issues new 10-year notes and 20-year bonds only
at the long end of the maturity spectrum, an existing 10-year Treasury bond would have to have
been issued 10 years previously (i.e., it was originally a 20-year bond when it was issued 10 years
previously). The increased demand for the newly
issued “liquid” 20-year Treasury bonds relative to
the less liquid 10-year Treasury bonds can be large
enough to push the equilibrium interest rate on the
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Chapter 8
220
Part Two
FIGURE 8B–1
Measuring Risk
Treasury Yield Curves
Source: U.S. Treasury, “Daily Treasury Rates.” www.ustreas.gov
(a) Yield Curve, May 29, 2012
Yield 3.00
to
maturity
2.00
1.00
Time
to
maturity
0.00
1-month 3-month 6-month 1-year
Yield 7.00
to
maturity
2-year
3-year
5-year
7-year 10-year 20-year 30-year
(b) Yield Curve, November 24, 2000
6.00
Time
to
maturity
5.00
3-month 6-month
1-year
2-year
3-year
5-year
7-year
10-year 20-year 30-year
(c) Yield Curve, June 4, 2007
Yield 5.50
to
maturity
5.00
4.50
Time
to
maturity
4.00
3-month 6-month
1-year
2-year
3-year
5-year
7-year
20-year Treasury bonds below that on the 10-year
Treasury bonds and even below short-term rates.
Explanations for the shape of the yield curve fall
predominantly into three theories: the unbiased
expectations theory, the liquidity premium theory,
and the market segmentation theory.
10-year
20-year
30-year
UNBIASED EXPECTATIONS
THEORY
According to the unbiased expectations theory
for the term structure of interest rates, at a given
point in time the yield curve reflects the market’s
Chapter 8
FIGURE 8B–2
221
Unbiased Expectations Theory of the Term Structure of Interest Rates
(1+1R1)
[1+E(2r1)]
[1+E(3r1)]
[1+E(4r1)]
Buy 4 one-year bonds
(1 + 1R4)4
0
Interest Rate Risk I
1
2
Buy a four-year bond
3
current expectations of future short-term rates.
Thus, an upward-sloping yield curve reflects the
market’s expectation that short-term rates will
rise throughout the relevant time period (e.g., the
Federal Reserve is expected to tighten monetary
policy in the future). Similarly, a flat yield curve
reflects the expectation that short-term rates will
remain constant over the relevant time period.
As illustrated in Figure 8B–2, the intuition
behind the unbiased expectations theory is that
if investors have a 4-year investment horizon,
they either could buy a current 4-year bond and
earn the current yield on a 4-year bond each year
(1R4, if held to maturity) or could invest in 4 successive one-year bonds (of which they know only
the current one-year rate, 1R1, but form expectations of the unknown future one-year rates). In
equilibrium, the return to holding a 4-year bond
to maturity should equal the expected return to
investing in 4 successive one-year bonds. Similarly, the return on a 3-year bond should equal the
expected return on investing in 3 successive oneyear bonds. If future one-year rates are expected
to rise each successive year into the future, then
the yield curve will slope upward. Specifically, the
current 4-year T-bond rate or return will exceed
the 3-year bond rate, which will exceed the 2-year
bond rate, and so on. Similarly, if future one-year
rates are expected to remain constant each successive year into the future, then the 4-year bond
rate will be equal to the 3-year bond rate. That is,
the term structure of interest rates will remain
constant over the relevant time period. Specifically, the unbiased expectations theory posits that
long-term rates are a geometric average of current
and expected short-term interest rates. That is, the
interest rate that equates the return on a series of
short-term security investments with the return
on a long-term security with an equivalent maturity reflects the market’s forecast of future interest
4
Year
rates. The mathematical equation representing
this relationship is:
(1 1 RN )N (1 1 R1 ) [1 E( 2 r1 )] ... [1 E( N r1 )]
where
1 RN
Actual N -period rate
N Term to maturity
Current one-year rate
1 R1
E( t r1 ) Expected one-year (forward) yield
during period t
Notice that uppercase interest rate terms, 1Rt, are
the actual current interest rates on securities purchased today with a maturity of t years. Lowercase interest rate terms, tr1, are estimates of future
one-year interest rates starting t years into the
future. For example, suppose the current oneyear spot rate and expected one-year Treasury bill
rates over the following three years (i.e., years 2,
3, and 4, respectively) are as follows:
2.94%
E( 2 r1 ) 4.00%
E( 3 r1 ) 4.74%
E( 4 r1 ) 5.10%
1 R1
This would be consistent with the market’s expecting the Federal Reserve to increasingly tighten monetary policy. With the unbiased expectations theory,
current long-term rates for one-, two-, three-, and
four-year maturity Treasury securities should be:
1 R1
2.940%
1 R2
[(1 0.0294)(1 0.04)]1/2 1 3.47%
1 R3
1/3
[(1 0.0294)(1 0.04)(1 0.0474)] 1
3.89%
1 R4
[(1 0.0294)(1 0.04)(1 0.0474)
(1 0.051)]1/ 4 1 4.19%
222
Part Two
Measuring Risk
And the yield curve should look like this:
Yield to
maturity (%)
4.19
3.89
3.47
2.94
0
1
2
3
4
Term to
maturity
(years)
Thus, the upward-sloping yield curve reflects the
market’s expectation of consistently rising oneyear (short-term) interest rates in the future.
LIQUIDITY PREMIUM THEORY
The unbiased expectations theory has the shortcoming that it neglects to recognize that forward
rates are not perfect predictors of future interest
rates. If forward rates were perfect predictors
of future interest rates, future prices of Treasury securities would be known with certainty.
The return over any investment period would
be certain and independent of the maturity of the
instrument initially purchased and of the time at
which the investor needs to liquidate the security.
However, with uncertainty about future interest
rates (and future monetary policy actions) and
hence about future security prices, these instruments become risky in the sense that the return
over a future investment period is unknown. In
other words, because of future uncertainty of
returns, there is a risk in holding long-term securities, and that risk increases with the security’s
maturity.
The liquidity premium theory of the term
structure of interest rates allows for this future
uncertainty. It is based on the idea that investors
will hold long-term maturities only if they are
offered a premium to compensate for the future
uncertainty in a security’s value, which increases
with an asset’s maturity. Specifically, in a world of
uncertainty, short-term securities provide greater
marketability (due to their more active secondary
market) and have less price risk (due to smaller
price fluctuations for a given change in interest
rates) than long-term securities. As a result, investors prefer to hold shorter-term securities because
they can be converted into cash with little risk
of a capital loss, that is, a fall in the price of the
security below its original purchase price. Thus,
investors must be offered a liquidity premium to
buy longer-term securities that have higher risk
of capital losses. This difference in price or liquidity risk can be directly related to the fact that
longer-term securities are more sensitive to interest rate changes in the market than are shorterterm securities—see Appendix 9A for a discussion
on bond interest rate sensitivity and the link to a
bond’s maturity. Because the longer the maturity
on a security the greater its risk, the liquidity premium increases as maturity increases.
The liquidity premium theory states that longterm rates are equal to the geometric average of
current and expected short-term rates (as with the
unbiased expectations theory) plus a liquidity or
risk premium that increases with the maturity of
the security. Figure 8B–3 illustrates the difference
in the shape of the yield curve under the unbiased
expectations theory versus the liquidity premium
theory. For example, according to the liquidity premium theory, an upward-sloping yield
curve may reflect the investor’s expectations
that future short-term rates will rise, be flat, or
fall, but because the liquidity premium increases
with maturity, the yield curve will nevertheless
increase with the term to maturity. The liquidity
premium theory may be mathematically represented as:
1 RN
{(1 1 R1 )[1 E( 2 r1 ) L2 ]...[1 E( N r1 )
LN ]}1/ N 1
where
Lt liquidity premium for a period t and
L 2 L3 . . . LN .
For example, suppose that the current one-year
rate (one-year spot rate) and expected one-year
T-bill rates over the following three years (i.e.,
years 2, 3, and 4, respectively) are as follows:
1 R1
2.94% E( 2 r1 ) 4.00%
E( 3 r1 ) 4.74%
E( 4 r1 ) 5.10%
Chapter 8
FIGURE 8B–3
Interest Rate Risk I
223
Yield Curve under the Unbiased Expectations Theory (UET) versus
the Liquidity Premium Theory (LPT)
(a) Upward-sloping
yield to
maturity
(b) Inverted or downward-sloping
yield to
maturity
LPT
LPT
UET
UET
Time to
maturity
Time to
maturity
(c) Flat
yield to
maturity
LPT
UET
Time to
maturity
In addition, investors charge a liquidity premium
on longer-term securities such that:
L2 0.10% L3 0.20% L4 0.30%
Using the liquidity premium theory, current rates
for one-, two-, three-, and four-year-maturity
Treasury securities should be:
1 R1
= 2.94%
1 R2
= [(1 + 0.0294)(1 + 0.04 + 0.001)]
1 R3
= [(1 + 0.0294)(1 + 0.04 + 0.001)(1 + 0.0474
1
2
− 1 = 3.52%
+ 0.002)]1 3 − 1 = 3.99%
1 R4
= [(1 + 0.0294)(1 + 0.04 + 0.001)(1 + 0.0474
+ 0.002)(1 + 0.051 + 0.003)]1 4 − 1 = 4.34%
and the current yield to maturity curve will be
upward sloping as shown:
Yield to maturity (%)
4.34
3.99
3.52
2.94
0 1
2
3
4
Term to maturity
(years)
Comparing the yield curves in the example above
(using the unbiased expectations hypothesis) and
here, notice that the liquidity premium in year 2
(L2 0.10%) produces a 0.05 percent premium
on the yield to maturity on a two-year T-note,
the liquidity premium for year 3 (L3 0.20%)
produces a 0.10 percent premium on the yield to
maturity on the three-year T-note, and the liquidity premium for year 4 (L4 0.30%) produces a
0.15 percent premium on the yield to maturity on
the four-year T-note.
MARKET SEGMENTATION
THEORY
Market segmentation theory argues that individual investors have specific maturity preferences.
Accordingly, securities with different maturities are not seen as perfect substitutes under the
market segmentation theory. Instead, individual
investors have preferred investment horizons dictated by the nature of the assets and liabilities they
hold. For example, banks might prefer to hold
relatively short-term U.S. Treasury bills because
of the short-term nature of their deposit liabilities, while insurance companies might prefer to
224
Part Two
FIGURE 8B–4
Yield
percent
rS
SS
Measuring Risk
Market Segmentation and Determination of the Slope of the Yield Curve
Yield
percent
rL
DS
Yield
percent
SL
DL
Yield
curve
Short-term
securities
Yield
percent
rS
SS
Long-term
securities
Yield
percent
rL
DS
S
L
Time to
maturity
Yield
percent
SL
DL
Yield
curve
Short-term
securities
Long-term
securities
hold long-term U.S. Treasury bonds because of
the long-term nature of their life insurance contractual liabilities. As a result, interest rates are
determined by distinct supply and demand conditions within a particular maturity bucket or
market segment (e.g., the short end and the long
end of the market). The market segmentation
theory assumes that neither investors nor borrowers are willing to shift from one maturity sector to another to take advantage of opportunities
arising from changes in yields. Figure 8B–4 demonstrates how changes in the supply curve for
short-versus long-term bonds result in changes in
the shape of the yield curve. Such a change may
occur if the U.S. Treasury decides to issue fewer
short-term bonds and more long-term bonds (i.e.,
to lengthen the average maturity of government
debt outstanding). Specifically in Figure 8B–4,
the higher the yield on securities, the higher the
demand for them.
Thus, as the supply of securities decreases in
the short-term market and increases in the longterm market, the slope of the yield curve becomes
steeper. If the supply of short-term securities
had increased while the supply of long-term
S
L
Time to
maturity
securities had decreased, the yield curve would
have become flatter (and may even have sloped
downward). Indeed, the large-scale repurchases
of long-term Treasury bonds (i.e., reductions in
supply) by the U.S. Treasury in 2000 have been
viewed as the major cause of the inverted yield
curve that appeared in 2000. More recently, in
2011 the Federal Reserve announced its Operation
Twist in which the Fed purchased $400 billion of
15- and 20-year Treasury bonds, and at the same
time, sold $400 billion of its short-term securities.
The name of the plan came from what the Fed
hoped the plan would do to the yield curve: flip it
around, or at least flatten the curve, so that longterm rates go down and short-term rates rise. In
June 2012, the Fed announced an extension of
Operation Twist involving a swap of $267 billion
short-term for long-term securities. Both moves
did immediately flatten the yield curve. Federal
Reserve Bank of San Francisco estimated that the
first round of Operation Twist, lowered long-term
yields by 15 basis points relative to short-term
yields. With the second round of Operation Twist,
the spread between long- and short-term rates fell
another 11 basis points.
Chapter 8
FORECASTING INTEREST RATES
As interest rates change, so do the values of financial securities. Accordingly, the ability to predict or
forecast interest rates is critical to the profitability
of FIs. For example, if interest rates rise, the value
of investment portfolios of FIs will fall, resulting
in a loss of wealth. Thus, interest rate forecasts
are extremely important for the financial wealth
of FIs. The discussion of the unbiased expectations theory above indicates that the shape of the
yield curve is determined by the market’s current
expectations of future short-term interest rates.
For example, an upward-sloping yield curve suggests that the market expects future short-term
interest rates to increase. Given that the yield
curve represents the market’s current expectations of future short-term interest rates, the unbiased expectations theory can be used to forecast
(short-term) interest rates in the future (i.e., forward one-year interest rates). A forward rate is an
expected or implied rate on a short-term security
that is to be originated at some point in the future.
With the equations representing the unbiased
expectations theory, the market’s expectation of
forward rates can be derived directly from existing or actual rates on securities currently traded
in the spot market.
To find an implied forward rate on a one-year
security to be issued one year from today, we can
rewrite the unbiased expectation theory equation
as follows:
1 R2
{(1 1 R1 )[1 ( 2 f1 )]}
1
2
1
where
2 f1
Expected one-year rate for year 2, or the
implied forward one-year rate for next
year
Interest Rate Risk I
225
Therefore, 2f1 is the market’s estimate of the
expected one-year rate for year 2. Solving for 2f1,
we get:
2 f1
{(1 1 R2 )2 / [1 ( 1 R1 )]} 1
In general, we can find the one-year forward rate
for any year, N years into the future, using the following equation:
N f1
{(1 1 RN )N / [1 ( 1 RN 1 )]N 1 } 1
For example, on May 29, 2012, the existing or
current (spot) one-year, two-year, three-year, and
four-year zero-coupon Treasury security rates
were as follows:
0.203%
1 R3 0.439%
1 R1
0.304%
1 R4 0.604%
1 R2
With the unbiased expectations theory, one-year
forward rates on zero-coupon Treasury bonds for
years 2, 3, and 4 as of May 29, 2012, were:
2 f1
[(1.00304)2 / (1.00203)] 1 1.004%
3 f1
[(1.00439)3 / (1.00304)2 ] 1 1.007%
4 f1
[(1.00604)4 / (1.00439)3 ] 1 1.011%
Thus, the expected one-year rate one year into the
future was 1.004 percent; the expected one-year
rate two years into the future was 1.007 percent;
and the expected one-year rate three years into
the future was 1.011 percent.
Chapter Nine
See Appendices Online at www.mhhe.com/saunders8e
• Appendix 9A: The Basics of Bond Valuation
Interest Rate Risk II
INTRODUCTION
book value
accounting
Accounting method
in which the assets
and liabilities of the
FI are recorded at historic values.
market value
accounting
Accounting method
in which the assets
and liabilities of the FI
are revalued according to the current
level of interest rates.
mark to market
Valuing securities at
their current market
price.
As mentioned in Chapter 8, a weakness of the repricing model is its reliance on
book values rather than market values of assets and liabilities. Indeed, in most
countries, FIs report their balance sheets by using book value accounting. This
method records the historic values of securities purchased, loans made, and liabilities sold. For example, for U.S. banks, investment assets (i.e., those expected to
be held to maturity) are recorded at book values, while those assets expected to
be used for trading (trading securities or available-for-sale securities) are reported
according to market value.1 The recording of market values means that assets and
liabilities are revalued to reflect current market conditions. Thus, if a fixed-coupon
bond had been purchased at $100 per $100 of face value in a low-interest rate
environment, a rise in current market rates reduces the present value of the cash
flows from the bond to the investor. Such a rise also reduces the price—say to
$97—at which the bond could be sold in the secondary market today. That is, the
market value accounting approach reflects economic reality, or the true values of
assets and liabilities if the FI’s portfolio were to be liquidated at today’s securities
prices rather than at the prices when the assets and liabilities were originally purchased or sold. This practice of valuing securities at their market value is referred
to as marking to market. We discuss book value versus market value accounting and the impact that the use of the alternate methods has in measuring the
value of an FI in more detail in Chapter 20. Appendix 9A, located at the book’s
website (www.mhhe.com/saunders8e), presents a review of bond pricing and
price volatility. This topic is generally covered in introductory finance courses. For
students needing a review, Appendix 9A is encouraged reading.
In this second chapter on measuring interest rate risk, we present a market
value–based model of managing interest rate risk: the duration gap model. We
explain the concept of duration and see that duration and the duration gap are
more accurate measures of an FI’s interest rate risk exposure than is the repricing gap model described in Chapter 8. Unlike the repricing gap model, duration
1
More accurately, they are reported at the lower of cost or current market value (LOCOM). However,
both the SEC and the Financial Accounting Standards Board (FASB) have strongly advocated that FIs
switch to full market value accounting in the near future. Currently, FASB 115 requires FIs to value certain
bonds at market prices but not loans.
226
Chapter 9
Interest Rate Risk II
227
gap considers market values and the maturity distributions of an FI’s assets and
liabilities. Further, duration gap considers the degree of leverage on an FI’s balance sheet as well as the timing of the payment or arrival of cash flows on assets
and liabilities. Thus, duration gap is a more comprehensive measure of an FI’s
interest rate risk. As a result, regulators are increasingly focusing on this model in
determining an appropriate level of capital reserves for an FI exposed to interest
rate risk (see Chapter 20). We begin the chapter by presenting the basic arithmetic needed to calculate the duration of an asset or liability. Then we analyze the
economic meaning of the number we calculate for duration. This number, which
measures the average life of an asset or liability, also has economic meaning as the
interest rate sensitivity (or interest elasticity) of that asset or liability’s value. Next,
we show how the duration measure can be used to protect an FI against interest
rate risk. Finally, we examine some problems in applying the duration measure
to real-world FIs’ balance sheets. The more advanced issues associated with these
problems are presented in Appendix 9B at the end of the chapter.
DURATION: A SIMPLE INTRODUCTION
Duration is a more complete measure of an asset or liability’s interest rate sensitivity than is maturity because duration takes into account the time of arrival (or
payment) of all cash flows as well as the asset’s (or liability’s) maturity. Consider
a loan with a 15 percent interest rate and required repayment of half the $100 in
principal at the end of six months and the other half at the end of the year. The
loan is financed with a one-year CD paying 15 percent interest per year. The promised cash flows (CF) received by the FI from the loan at the end of one-half year
and at the end of the year appear in Figure 9–1.
CF1/2 is the $50 promised repayment of principal plus the $7.50 promised interest payment ($100 ½ 15%) received after six months. CF1 is the promised
cash flow at the end of the year and is equal to the second $50 promised principal
repayment plus $3.75 promised interest ($50 ½ 15%). To compare the relative
sizes of these two cash flows, we should put them in the same dimensions. This is
the case because $1 of principal or interest received at the end of a year is worth
less to the FI in terms of the time value of money than $1 of principal or interest
received at the end of six months. Assuming that the current required interest
rates are 15 percent per year, we calculate the present values (PV) of the two cash
flows (CF) shown in Figure 9–2 as:
CF1/2 $57.50
PV1/2 $57.5/(1.075) $53.49
CF1 $53.75
PV1 $53.75/(1.075)2 $46.51
CF1/2 CF1 $111.25
PV1/2 PV1 $100.00
Note that since CF1/2, the cash flows received at the end of one-half year, are
received earlier, they are discounted at (1 ½R), where R is the current annual
CF1/2 = $57.50
FIGURE 9–1
Promised Cash
Flows on the OneYear Loan
0
1/2
year
CF1 = $53.75
1 year
228
Part Two
Measuring Risk
FIGURE 9–2
PV of the Cash
Flows from the
Loan
PV1 = $46.51
PV1/2 = $53.49
1/2
0
duration
The weighted-average
time to maturity on
an investment.
CF1 = $53.75
CF1/2 = $57.50
1 year
year
interest rate on the loan. This is smaller than the discount rate on the cash flow
received at the end of the year (1 ½R)2. Figure 9–2 summarizes the PVs of the
cash flows from the loan.
Technically speaking, duration is the weighted-average time to maturity on
the loan using the relative present values of the cash flows as weights. On a time
value of money basis, duration measures the weighted average of when cash flows
are received on the loan. As Figure 9–2 shows, the FI receives some cash flows at
one-half year and some at one year. Duration analysis weights the time at which
cash flows are received by the relative importance in present value terms of the cash
flows arriving at each point in time. In present value terms, the relative importance
of the cash flows arriving at time t ½ year and time t 1 year are as follows:
Time (t)
1/2 year
Weight (x)
X 1/ 2 PV1/2
53.49
0.5349 53.49%
PV1/2 PV1
100.00
X1 PV1
46.51
0.4651 46.51%
PV1/ 2 PV1
100.00
1 year
1.0
100%
That is, in present value terms, the FI receives 53.49 percent of cash flows on the
loan with the first payment at the end of six months (t ½) and 46.51 percent with
the second payment at the end of the year (t 1). By definition, the sum of the
(present value) cash flow weights must equal 1:
X 1/2 X 1 1
0.5349 0.4651 1
We can now calculate the duration (D), or the weighted-average time to maturity, of the loan using the present value of its cash flows as weights:
D1 X 1/2 ( 1 2) X 1 (1)
0.5349( 1 2) 0.4651(1) 0.7326 years
Thus, while the maturity of the loan is one year, its duration, or average life in a
cash flow sense, is only 0.7326 years. The duration is less than the maturity of the
loan because in present value terms 53.49 percent of the cash flows are received at
the end of one-half year. Note that duration is measured in years since we weight
the time (t) at which cash flows are received by the relative present value importance of cash flows (X1/2, X1, etc.).
We next calculate the duration of the one-year, $100, 15 percent interest certificate of deposit. The FI promises to make only one cash payment to depositors at
Chapter 9
FIGURE 9–3
PV1 = $100
PV of the Cash
Flows of the
Deposit
Interest Rate Risk II
229
CF1 = $115
1 year
0
the end of the year; that is, CF1 $115, which is the promised principal ($100) and
interest repayment ($15) to the depositor. Since weights are calculated in present
value terms:
CF1 $115, and PV1 $115/1.15 $100
We show this in Figure 9–3. Because all cash flows are received in one payment at
the end of the year, X1 PV1/PV1 1, the duration of the deposit is:
DD X 1 1
DD 1 1 1 year
Thus, only when all cash flows are limited to one payment at the end of the
period with no intervening cash flows does duration equal maturity. This example
also illustrates that while the maturities on the loan and the deposit are both
one year (and thus the difference or gap in maturities is zero), the duration gap is
negative:
ML MD 1 1 0
DL DD 0.7326 1 0.2674 years
As will become clearer, to measure and to hedge interest rate risk, the FI needs to
manage its duration gap rather than its maturity gap.
Concept
Questions
1. Why is duration considered a more complete measure of an asset or liability’s interest
rate sensitivity than maturity?
2. When is the duration of an asset equal to its maturity?
A GENERAL FORMULA FOR DURATION
You can calculate the duration (or Macaulay’s duration2) for any fixed-income
security that pays interest annually using the following general formula:
N
D ∑ CFt DFt t
t 1
N
∑ CFt DFt
t 1
2
N
∑ PVt t
t 1
N
∑ PVt
t 1
Named after an economist who was among the first to develop the duration concept.
(1)
230
Part Two
Measuring Risk
where
D Duration measured in years
CFt Cash flow received on the security at end of period t
N Last period in which the cash flow is received
DFt Discount factor 1/(1 R)t, where R is the annual yield or current
level of interest rates in the market
N
Summation
sign for addition of all terms from t 1 to t N
∑
t1
PVt Present value of the cash flow at the end of the period t, which equals
CFt DFt
For bonds that pay interest semiannually, the duration equation becomes:3
CFt t
2t
t 1 2 (1 R 2)
N
∑
D N
CF
∑ (1 Rt 2)2t
t 1 2
(2)
where t ½, 1, 1½, . . . , N.
A key assumption of the simple Macaulay duration model is that the yield curve
or the term structure of interest rates is flat and that when rates change, the yield
curve shifts in a parallel fashion. Further, the simple duration equation assumes
that the issuer of a security or the borrower of a loan pays the interest and principal as promised. That is, the equation assumes no default risk. As we go through
the theory and analysis of the duration model and interest rate risk in the body of
the chapter, we use the simple Macaulay duration model and these assumptions.
In Appendix 9B, we relax these assumptions, allowing for something other than a
flat yield curve and default risk. Relaxing these assumptions changes the formulas in the body of the chapter slightly. However, the intuition and general trends
remain the same as those seen in the body of the chapter.
Notice that the denominator of the duration equation is the present value of the
cash flows on the security (which in an efficient market will be equal to the current market price). The numerator is the present value of each cash flow received
on the security multiplied or weighted by the length of time required to receive
the cash flow. To help you fully understand this formula, we next look at some
examples. Table 9–1 summarizes duration and its features, which we illustrate in
the examples.
3
In general, the duration equation is written as:
N
D ∑
t 1/ m
N
∑
t 1/ m
CFt t
(1 R / m)mt
CFt
(1 R / m)mt
where m number of times per year interest is paid.
Chapter 9
TABLE 9–1
Duration:
Definition and
Features
Interest Rate Risk II
231
Definition of Duration
1. The weighted-average time to maturity on a security.
2. The interest elasticity of a security’s price to small interest rate changes.
Features of Duration
1. Duration increases with the maturity of a fixed-income security, but at a
decreasing rate.
2. Duration decreases as the yield on a security increases.
3. Duration decreases as the coupon or interest payment increases.
Risk Management with Duration
1. Duration is equal to the maturity of an immunized security.
2. Duration gap is used by FIs to measure and manage the interest rate risk of an overall
balance sheet.
The Duration of Interest-Bearing Bonds
EXAMPLE 9–1
The Duration
of a Six-Year
Eurobond
TABLE 9–2
Duration of a SixYear Eurobond with
8 Percent Coupon
and Yield
Eurobonds pay coupons annually. Suppose a Eurobond matures in 6 years, the annual coupon is 8 percent, the face value of the bond is $1,000, and the current yield to maturity (R) is
also 8 percent. We show the calculation of its duration in Table 9–2. Column 1 lists the time
period (in years) in which a cash flow (CF) is received. Column 2 lists the CF received in time
period t. Column 3 lists the discount factor used to convert a future value to a present value.
Column 4 is the present value of the CF received in each period t (Column 2 times Column 3).
The sum of Column 4 is the present value of the bond: the denominator of the duration
equation. Column 5 is the present value of the CF received each period times the time it takes
to receive the CF (Column 4 times Column 1). The sum of Column 5 is the time weighted
present value of the bond: the numerator of the duration equation. As the calculation indicates, the duration or weighted-average time to maturity on this bond is 4.993 years.
t
CFt
DFt
1
2
3
4
5
6
80
80
80
80
80
1,080
0.9259
0.8573
0.7938
0.7350
0.6806
0.6302
D =
CFt ⴛ DFt
CFt ⴛ DFt ⴛ t
74.07
68.59
63.51
58.80
54.45
680.58
74.07
137.18
190.53
235.20
272.25
4,083.48
1,000.00
4,992.71
4, 992.71
= 4.993 years
1, 000
232
Part Two
Measuring Risk
EXAMPLE 9–2
The Duration of
a Two-Year U.S.
Treasury Bond
U.S. Treasury bonds pay coupon interest semiannually. Suppose a Treasury bond matures in
two years, the annual coupon rate is 8 percent, the face value is $1,000, and the annual yield
to maturity (R) is 12 percent. See Table 9–3 for the calculation of the duration of this bond.
As the calculation indicates, the duration, or weighted-average time to maturity, on this bond
is 1.883 years. Table 9–4 shows that if the annual coupon rate is lowered to 6 percent, duration rises to 1.909 years. Since 6 percent coupon payments are lower than 8 percent, it takes
longer to recover the initial investment in the bond. In Table 9–5 duration is calculated for
the original 8 percent bond, assuming that the yield to maturity increases to 16 percent. Now
duration falls from 1.883 years (in Table 9–3) to 1.878 years. The higher the yield to maturity
on the bond, the more the investor earns on reinvested coupons and the shorter the time to
recover the initial investment. Finally, when the maturity on a bond decreases to 1 year (see
Table 9–6), its duration falls to 0.980 year. Thus, the shorter the maturity on the bond, the
more quickly the initial investment is recovered.
TABLE 9–3
Duration of a TwoYear U.S. Treasury
Bond with 8 Percent
Coupon and 12
Percent Yield
t
CFt
DFt
CFt ⴛ DFt
CFt ⴛ DFt ⴛ t
½
1
1½
2
40
40
40
1,040
0.9434
0.8900
0.8396
0.7921
37.74
35.60
33.58
823.78
930.70
18.87
35.60
50.37
1,647.56
1,752.40
D TABLE 9–4
Duration of a TwoYear U.S. Treasury
Bond with 6 Percent
Coupon and 12
Percent Yield
t
½
1
1½
2
CFt
DFt
CFt ⴛ DFt
CFt ⴛ DFt ⴛ t
30
30
30
1,030
0.9434
0.8900
0.8396
0.7921
28.30
26.70
25.19
815.86
14.15
26.70
37.78
1,631.71
896.05
1,710.34
D TABLE 9–5
Duration of a TwoYear U.S. Treasury
Bond with 8 Percent
Coupon and 16
Percent Yield
t
½
1
1½
2
1,752.40
1.883 years
930.70
1,710.34
1.909 years
896.05
CFt
DFt
CFt ⴛ DFt
CFt ⴛ DFt ⴛ t
40
40
40
1,040
0.9259
0.8573
0.7938
0.7350
37.04
34.29
31.75
764.43
18.52
34.29
47.63
1,528.86
867.51
1,629.30
D 1,629.30
1.878 years
867.51
Chapter 9
TABLE 9–6
Duration of a OneYear U.S. Treasury
Bond with 8 Percent
Coupon and 12
Percent Yield
t
½
1
CFt
DFt
CFt ⴛ DFt
40
1,040
0.9434
0.8900
37.74
925.60
963.34
D Interest Rate Risk II
233
CFt ⴛ DFt ⴛ t
18.87
925.60
944.47
944.47
0.980 year
963.34
Next, we look at two other types of bonds that are useful in understanding
duration.
The Duration of Zero-Coupon Bonds
The U.S. Treasury has created zero-coupon bonds that allow securities firms and
other investors to strip individual coupons and the principal from regular Treasury bonds and sell them to investors as separate securities. Elsewhere, such as
in the corporate bond markets, corporations have issued discount or zero-coupon
bonds directly. U.S. T-bills and commercial paper usually are issued on a discount
basis and are additional examples of discount bonds. These bonds sell at a discount from face value on issue, pay the face value (e.g., $1,000) on maturity, and
have no intervening cash flows, such as coupon payments, between issue and
maturity. The current price an investor is willing to pay for such a bond is equal
to the present value of the single, fixed (face value) payment on the bond that is
received on maturity (here, $1,000), or:
P 1,000
(1 R)N
where R is the required annually compounded yield to maturity, N is the number
of years to maturity, and P is the price. Because there are no intervening cash flows
such as coupons between issue and maturity, the following must be true:
DB MB
That is, the duration of a zero-coupon bond equals its maturity. Note that only for
zero-coupon bonds are duration and maturity equal. Indeed, for any bond that
pays some cash flows prior to maturity, its duration will always be less than its
maturity.
The Duration of Consol Bonds (Perpetuities)
consol bond
A bond that pays a
fixed coupon each
year forever.
Although consol bonds have yet to be issued in the United States, they are of
theoretical interest in exploring the differences between maturity and duration.
A consol bond pays a fixed coupon each year. The novel feature of this bond is
that it never matures; that is, it is a perpetuity:
Mc 234
Part Two
Measuring Risk
In fact, consol bonds that were issued by the British government in the 1890s
to finance the Boer Wars in South Africa are still outstanding. However, while its
maturity is theoretically infinity, the formula for the duration of a consol bond is:
Dc 1 1
R
where R is the required yield to maturity. Suppose that the yield curve implies
R 5 percent annually. Then the duration of the consol bond would be:
Dc 1 1
21 years
0.05
Thus, while maturity is infinite, duration is finite. Moreover, as interest rates rise,
the duration of the consol bond falls. Consider the 1979–82 period, when some
yields rose to around 20 percent on long-term government bonds. Then:
Dc 1 Concept
Questions
1
6 years
0.2
1. What does the denominator of the duration equation measure?
2. What does the numerator of the duration equation measure?
3. Calculate the duration of a one-year, 8 percent coupon, 10 percent yield bond that
pays coupons quarterly.
4. What is the duration of a zero-coupon bond?
5. What feature is unique about a consol bond compared with other bonds?
FEATURES OF DURATION
From the preceding examples, we derive three important features of duration
relating to the maturity, yield, and coupon interest of the security being analyzed.
Duration and Maturity
A comparison of Tables 9–6, 9–3, and 9–7 indicates that duration increases with the
maturity of a fixed-income asset or liability, but at a decreasing rate:4
∂D
0
∂M
∂2 D
0
∂M2
To see this, look at Figure 9–4, where we plot duration against maturity for a
three-year, a two-year, and a one-year U.S. Treasury bond using the same yield of
4
This is the case for the vast majority of securities. It needs to be noted, however, that for bonds selling
below par, duration increases at a decreasing rate up to a point. At long maturities (e.g., 50 years) duration starts to decline. Few bonds in the market have a maturity long enough to see this decline.
Chapter 9
TABLE 9–7
Duration of a
Three-Year U.S.
Treasury Bond with
8 Percent Coupon
and 12 Percent Yield
(Coupon Interest
Paid Semiannually)
t
½
1
1½
2
2½
3
CFt
DFt
CFt ⴛ DFt
CFt ⴛ DFt ⴛ t
40
40
40
40
40
1,040
0.9434
0.8900
0.8396
0.7921
0.7473
0.7050
37.04
35.60
33.58
31.68
29.89
733.16
18.87
35.60
50.37
63.36
74.72
2,199.48
901.65
2,442.40
D FIGURE 9–4
Interest Rate Risk II
235
2,442.40
2.709 years
901.65
Duration
Duration versus
Maturity
2.709 years
1.883 years
0.980 year
1 year
2 years
3 years
Maturity
∞
12 percent for all three and assuming an annual coupon of 8 percent (with semiannual payments of 4 percent) on each bond. As the maturity of the bond increases
from one year to two years (Tables 9–6 and 9–3), duration increases by 0.903 year,
from 0.980 year to 1.883 years. Increasing maturity an additional year, from two years
to three years (Tables 9–3 and 9–7), increases duration by 0.826, from 1.883 years to
2.709 years.
Duration and Yield
A comparison of Tables 9–3 and 9–5 indicates that duration decreases as yield
increases:
∂D
0
∂R
As the yield on the Treasury bond increases from 12 percent to 16 percent
(Tables 9–3 and 9–5), the duration on the bond decreases from 1.883 years to 1.878
years. This makes sense intuitively because higher yields discount later cash flows
more heavily and the relative importance, or weights, of those later cash flows
decline when compared with earlier cash flows on an asset or liability.
Duration and Coupon Interest
A comparison of Tables 9–4 and 9–3 indicates that the higher the coupon or promised interest payment on the security, the lower its duration:
∂D
0
∂C
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As the coupon rate on the U.S. Treasury bond increases from 6 percent to 8 percent in Tables 9–4 and 9–3, the duration on the bond decreases from 1.909 years to
1.883 years. This is due to the fact that the larger the coupons or promised interest
payments, the more quickly cash flows are received by investors and the higher
are the present value weights of those cash flows in the duration calculation. On a
time value of money basis, the investor recoups the initial investment faster when
coupon payments are larger.
Concept
Questions
1. Which has the longest duration, a 30-year, 8 percent, zero-coupon or discount bond
or an 8 percent infinite maturity consol bond?
2. What is the relationship between duration and yield to maturity on a financial
security?
3. Do high-coupon bonds have high or low durations?
THE ECONOMIC MEANING OF DURATION
So far we have calculated duration for a number of different fixed-income assets
and liabilities. Now we are ready to make the direct link between the number
measured in years we call duration and the interest rate sensitivity of an asset or
liability or of an FI’s entire portfolio.
In addition to being a measure of the average life, in a cash flow sense, of an
asset or liability, duration is also a direct measure of the interest rate sensitivity, or
elasticity, of an asset or liability. In other words, the larger the numerical value of
D, the more sensitive is the price of that asset or liability to changes or shocks in
interest rates.
Consider the following equation showing that the current price of a bond that
pays interest annually is equal to the present value of the coupons and principal
payment on the bond:
P C
C
CF
…
(1 R)
(1 R)2
(1 R)N
(3)
where
P Price on the bond
C Coupon or interest payment (annual)
R Yield to maturity
N Number of periods to maturity
F Face value of the bond
We want to find out how the price of the bond (P) changes when yields (R) rise.
We know that bond prices fall, but we want to derive a direct measure of the size
of this fall (i.e., its degree of price sensitivity).
Chapter 9
Interest Rate Risk II
237
Taking the derivative of the bond’s price (P) with respect to the yield to maturity (R), we can show that:5
1
dP
( P D)
1R
dR
By cross multiplying:
dP
1R
D
dR
P
or, alternatively, and recognizing that interest rate changes tend to be discrete:6
P
P
D
R
1R
interest elasticity
The percentage
change in the price of
a bond for any given
change in interest
rates.
(4)
The economic interpretation of equation (4) is that the number D is the interest elasticity, or sensitivity, of the security’s price to small interest rate changes. That is, D
5
The first derivative of the bond’s price in equation (3) with respect to the yield to maturity (R) is:
dP
C
2C
N (C F )
…
dR
(1 R )2
(1 R )3
(1 R )N 1
By rearranging, we get:
1 ⎡ C
2C
dP
N (C F ) ⎤
…
1 R ⎢⎣ (1 R )
dR
(1 R )2
(1 R )N ⎥⎦
(A)
We have shown that duration (D) is the weighted-average time to maturity using the present value of
cash flows as weights; that is, by definition:
D 1
C
C
(C F )
2
… N (1 R )
(1 R )2
(1 R )N
C
C
(C F )
…
(1 R )
(1 R )2
(1 R )N
Since the denominator of the duration equation is simply the price (P) of the bond that is equal to the
present value of the cash flows on the bond, then:
D 1
C
C
(C F )
2
… N (1 R )
(1 R )2
(1 R )N
P
Multiplying both sides of this equation by P, we get:
P D 1
C
C
C F
2
… N (1 R )
(1 R )2
(1 R )N
(B)
The term on the right side of equation (B) is the same term as that in square brackets in equation (A).
Substituting equation (B) into equation (A), we get:
dP
1
[P D ]
dR
1 R
6
In what follows, we use the ∆ (change) notation instead of d (derivative notation) to recognize that
interest rate changes tend to be discrete rather than infinitesimally small. For example, in real-world
financial markets, the smallest observed rate change is usually one basis point, or 1/100th of 1 percent.
238
Part Two
Measuring Risk
describes the percentage price fall of the bond (ΔP/P) for any given (present value)
increase in required interest rate or yield (ΔR/(1 R)).
Equation (4) can be rearranged in another useful way for interpretation regarding interest rate sensitivity. That is, the percentage change in the price of a bond
for a change in interest rates can be written as:
P
⎡ R ⎤
D ⎢
P
⎣ 1 R ⎥⎦
modified duration
Duration divided by 1
plus the interest rate.
(5)
Equation (5) shows that for small changes in interest rates, bond prices move in
an inversely proportional fashion according to the size of D. Clearly, for any given
change in interest rates, long duration securities suffer a larger capital loss (or
receive a higher capital gain) should interest rates rise (fall) than do short-duration
securities. By implication, gains and losses under the duration model are symmetric. That is, if we repeat the above examples but allow interest rates to decrease
by one basis point annually (or 1/2 basis point semiannually), the percentage
increase in the price of the bond (ΔP/P) would be proportionate with D. Further,
the capital gains would be a mirror image of the capital losses for an equal (small)
increase in interest rates.
The duration equation can be rearranged, combining D and (1 R) into a single
variable D/(1 R), to produce what practitioners call modified duration (MD).
For annual compounding of interest:
P
MD dR
P
where
MD dollar duration
The dollar value
change in a security’s
price to a 1 percent
change in the return
on the security.
D
1R
This form is more intuitive because we multiply MD by the simple change in
interest rates rather than the discounted change in interest rates as in the general
duration equation.
Duration is a measure of the percentage change in the price of a security for a
1 percent change in the return on the security. Dollar duration is the dollar value
change in the price of a security to a 1 percent change in the return on the security. The dollar duration is defined as the modified duration times the price of a
security:
Dollar duration MD P
Thus, the total dollar value of a security will change by an amount equal to the
dollar duration times the change in the return on the security:
P Dollar duration R
Like the modified duration, the dollar duration is intuitively appealing in that
we multiply the dollar duration by the change in the interest rate to get the actual
Chapter 9
Interest Rate Risk II
239
dollar change in the value of a security to a change in interest rates.7 Next, we use
duration to measure the interest sensitivity of an asset or liability.
EXAMPLE 9–3
The Six-Year
Eurobond
Consider Example 9–1 for the six-year Eurobond with an 8 percent coupon and 8 percent
yield. We determined in Table 9–2 that its duration was approximately D 4.993 years. The
modified duration is:
MD D/(1 R) 4.993/1.08 4.623
That is, the price of the bond will increase by 4.623 percent for a 1 percent decrease in the
interest rate on the bond. Further, the dollar duration is:
Dollar duration 4.623 $1,000 4,623
or a 1 percent (or 100 basis points) change in the return on the bond would result a change
of $46.23 in the price of the bond.
To see this, suppose that yields were to rise by one basis point (1/100th of 1 percent) from
8 to 8.01 percent. Then:
P
⎡ 0.0001 ⎤
(4.993) ⎢
P
⎣ 1.08 ⎥⎦
0.000462 or 0.0462%
The bond price had been $1,000, which was the present value of a six-year bond with 8
percent coupons and 8 percent yield. The duration model, and specifically dollar duration,
predicts that the price of the bond would fall to $999.5377 after the increase in yield by one
basis point. That is, the price would change by:
P Dollar duration R
4623 0.0001 $0.463
EXAMPLE 9–4
The Consol Bond
Consider a consol bond with an 8 percent coupon paid annually, an 8 percent yield, and
a calculated duration of 13.5 years (Dc 1 1/0.08 13.5). Thus, for a one-basis-point
change in the yield (from 8 percent to 8.01 percent):
P
⎡ 0.0001 ⎤
(13.5) ⎢
P
⎣ 1.08 ⎥⎦
0.00125 or 0.125%
7
Another measure of interest sensitivity is spread duration. Spread duration is the sensitivity of the price
of a bond to a change in its option-adjusted spread (OAS). OAS, discussed in Chapter 26, is the required
interest spread of a pass-through or mortgage-backed security over a Treasury rate when prepayment risk
is taken into account. Since mortgage payers tend to exercise their right to prepay when it is favorable
for them, buying a pass-through or mortgage-backed security partly involves selling an option. This is the
source of the option-adjusted spread. Thus, spread duration is the price sensitivity of the pass-through or
mortgage-backed security to a change in the OAS. A change in the OAS of a pass-through or mortgagebacked security does not affect the cash flows that the security pays to the investor. Thus, spread duration
is the impact of these cash flows at varying interest rates. We discuss this in more detail in Chapter 26.
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As you can see, for any given change in yields, long-duration securities suffer a greater capital loss or receive a greater capital gain than do short-duration
securities.
Semiannual Coupon Bonds
For fixed-income assets or liabilities whose interest payments are received semiannually or more frequently than annually, the formula in equation (5) has to be
modified slightly. For semiannual payments the percentage change in the price of
a bond for a change in interest rates is:
P
R ⎤
⎡
D ⎢
⎥
P
⎣ 1 12 R ⎦
(6)
The only difference between equation (6) and equation (5) is the introduction of a
½ in the discount rate term 1 ½R to take into account the semiannual payments
of interest.
EXAMPLE 9–5
Semiannual
Coupon, TwoYear Maturity
Treasury Bonds
Recall from Example 9–2 the two-year T-bond with semiannual coupons whose duration we
derived in Table 9–3 as 1.883 years when annual yields were 12 percent. The modified duration is:
MD D/(1 R) 1.883/1.06 1.776
That is, the price of the bond will increase by 1.776 percent for a 1 percent decrease in the
interest rate on the bond. Further, the dollar duration is:
Dollar duration 1.776 $930.70 1,653
or a 1 percent (or 100 basis points) change in the return on the bond would result a change
of $16.53 in the price of the bond.
Thus, a one-basis-point rise in interest rates would have the following predicted effect
on price:
P
⎡ 0.0001 ⎤
1.883 ⎢
P
⎣ 1.06 ⎥⎦
0.0001776
or the price of the bond would fall by 0.01776 percent from $930.6979 to $930.5326.
That is,
P Dollar duration R
$16.53 0.0001 $0.1653
Concept
Questions
1. What is the relation between the duration of a bond and the interest elasticity of a
bond?
2. How would the formula in equation (6) have to be modified to take into account
quarterly coupon payments and monthly coupon payments?
Chapter 9
Interest Rate Risk II
241
DURATION AND INTEREST RATE RISK
So far, you have learned how to calculate duration and you understand that the
duration measure has economic meaning because it indicates the interest sensitivity,
or elasticity, of an asset or liability’s value. For FIs, the major relevance of duration
is as a measure for managing interest rate risk exposure. Also important is the role
of duration in allowing the FI to reduce and even eliminate interest rate risk on its
balance sheet or some subset of that balance sheet. In the following sections we consider two examples of how FIs can use the duration measure to manage interest rate
risk. The first is its use by insurance company and pension fund managers to help
meet promised cash flow payments to policyholders or beneficiaries at a particular
time in the future. The second is its use to reduce or immunize the whole balance
sheet of an FI against interest rate risk.
Duration and Interest Rate Risk Management
on a Single Security
Frequently, pension fund and life insurance company managers face the problem
of structuring their asset investments so they can pay out a given cash amount to
policyholders in some future period. The classic example of this is an insurance
policy that pays the holder some lump sum on reaching retirement age. The risk to
the life insurance company manager is that interest rates on the funds generated
from investing the holder’s premiums could fall. Thus, the accumulated returns
on the premiums invested could not meet the target or promised amount. In effect,
the insurance company would be forced to draw down its reserves and net worth
to meet its payout commitments. (See Chapter 6 for a discussion of this risk.)
Suppose that we are in 2016 and the insurer has to make a guaranteed payment
to a policyholder in five years, 2021. For simplicity, we assume that this target guaranteed payment is $1,469, a lump-sum policy payout on retirement, equivalent to
investing $1,000 at an annually compounded rate of 8 percent over five years. Of
course, realistically, this payment would be much larger, but the underlying principles of the example do not change by scaling up or down the payout amount.
To immunize, or protect, itself against interest rate risk, the insurer needs to
determine which investments would produce a cash flow of exactly $1,469 in five
years regardless of what happens to interest rates in the immediate future. The
FI investing either in a five-year maturity and duration zero-coupon bond or in a
coupon bond with a five-year duration would produce a $1,469 cash flow in five
years no matter what happened to interest rates in the immediate future. Next,
we consider the two strategies: buying five-year maturity (and duration) deepdiscount bonds and buying five-year duration coupon bonds.
Buy Five-Year Maturity Discount Bonds
Given a $1,000 face value, an 8 percent yield, and assuming annual compounding,
the current price per five-year discount bond would be $680.58 per bond:
P 680.58 1,000
(1.08)5
If the insurer bought 1.469 of these bonds at a total cost of $1,000 in 2016,
these investments would produce exactly $1,469 on maturity in five years
($1,000 (1.08)5 $1,469). The reason is that the duration of this bond portfolio
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Measuring Risk
exactly matches the target horizon for the insurer’s future liability to its policyholder. Intuitively, since no intervening cash flows or coupons are paid by the
issuer of the zero-coupon discount bonds, future changes in interest rates have no
reinvestment income effect. Thus, the return would be unaffected by intervening
interest rate changes.
Buy a Five-Year Duration Coupon Bond
Suppose no five-year discount bonds exist. Then the portfolio manager may seek to
invest in appropriate duration coupon bonds to hedge interest rate risk. In this example the appropriate investment would be in five-year duration coupon bearing bonds.
We demonstrated earlier in Table 9–2 that a six-year maturity Eurobond paying 8 percent coupons with an 8 percent yield to maturity had a duration of
4.993 years, or approximately five years. If we buy this six-year maturity, fiveyear duration bond in 2016 and hold it for five years, until 2021, the term exactly
matches the target horizon of the insurer. The cash flows generated at the end of
five years will be $1,469 whether interest rates stay at 8 percent or instantaneously
(immediately) rise to 9 percent or fall to 7 percent. Thus, buying a coupon bond
whose duration exactly matches the time horizon of the insurer also immunizes
the insurer against interest rate changes.
EXAMPLE 9–6
Interest Rates
Remain at 8
Percent
The cash flows received by the insurer on the bond if interest rates stay at 8 percent throughout the five years would be
1. Coupons, 5 $80
2. Reinvestment income
3. Proceeds from sale of bond at end of fifth year
$ 400
69
1,000
$1,469
We calculate each of the three components of the insurer’s income from the bond investment as follows:
1. Coupons. The $400 from coupons is simply the annual coupon of $80 received in each of
the five years.
2. Reinvestment income. Because the coupons are received annually, they can be reinvested
at 8 percent as they are received, generating an additional cash flow of $69.8
8
Receiving annual coupons of $80 is equivalent to receiving an annuity of $80. The appropriate terminal
value of receiving $1 a year for five years and reinvesting at 8 percent can be determined from the future
value of an annuity (FVA) formula:
⎡ (1 R )n 1 ⎤
FVAn, R ⎢
⎥
R
⎦
⎣
In our example:
FVA
5, 8%
⎡ (1 0.08)5 1 ⎤
⎥ 5.867
⎢
0.08
⎦
⎣
Thus, the reinvestment income for $80 of coupons per year is:
Reinvestment income (80 5.867) 400 469 400 69
Note that we take away $400 since we have already counted the simple coupon income (5 $80).
Chapter 9
Interest Rate Risk II
243
3. Bond sale proceeds. The proceeds from the sale are calculated by recognizing that the six
year bond has just one year left to maturity when it is sold by the insurance company at
the end of the fifth year. That is:
↓ Sell
$1,080
Year 5
(2021)
Year 6
(2022)
What fair market price can the insurer expect to get when selling the bond at the end
of the fifth year with one year left to maturity? A buyer would be willing to pay the present
value of the $1,080—final coupon plus face value—to be received at the end of the one
remaining year (i.e., in 2022), or:
P5 1, 080
$1, 000
1.08
Thus, the insurer would be able to sell the one remaining cash flow of $1,080, to be received
in the bond’s final year, for $1,000.
Next, we show that since this bond has a duration of five years, matching the
insurer’s target period, even if interest rates were to instantaneously fall to 7 percent or rise to 9 percent, the expected cash flows from the bond would still exactly
sum to $1,469. That is, the coupons reinvestment income principal at the end
of the fifth year would be immunized. In other words, the cash flows on the bond
are protected against interest rate changes.
EXAMPLE 9–7
Interest Rates
Fall to 7 Percent
In this example with falling interest rates, the cash flows over the five years would be:
1. Coupons, 5 $80
2. Reinvestment income
3. Bond sale proceeds
$ 400
60
1,009
$1,469
The total proceeds over the five years are unchanged from what they were when interest
rates were 8 percent. To see why this occurs, consider what happens to the three parts of the
cash flow when rates fall to 7 percent:
1. Coupons. Are unchanged since the insurer still gets five annual coupons of $80 $400.
2. Reinvestment income. The coupons can now be reinvested only at the lower rate of 7 percent.
Reinvestment income is only $60, which is $9 less than it was when rates were 8 percent.9
9
This reinvestment income is calculated as follows.
FVA
5, 7%
⎡ (1 0.07)5 1 ⎤
⎥ 5.751
⎢
0.07
⎦
⎣
Reinvestment income (5.751 80) 400 60.
244
Part Two
Measuring Risk
3. Bond sale proceeds. When the six-year maturity bond is sold at the end of the fifth year
with one cash flow of $1,080 remaining, investors are now willing to pay more:
P5 1,080
1,009
1.07
That is, the bond can be sold for $9 more than it could have when rates were 8 percent. The
reason for this is that investors can get only 7 percent on newly issued bonds, while this older
bond was issued with a higher coupon of 8 percent.
A comparison of reinvestment income with bond sale proceeds indicates that the fall in
rates has produced a gain on the bond sale proceeds of $9. This exactly offsets the loss of
reinvestment income of $9 due to reinvesting at a lower interest rate. Thus, total cash flows
remain unchanged at $1,469.
EXAMPLE 9–8
Interest Rates
Rise to 9 Percent
In this example with rising interest rates, the proceeds from the bond investment are:
1. Coupons, 5 $80
2. Reinvestment income [(5.985 80) 400]
3. Bond sale proceeds (1,080/1.09)
$ 400
78
991
$1,469
Notice that the rise in interest rates from 8 percent to 9 percent leaves the final terminal
cash flow unaffected at $1,469. The rise in rates has generated $9 extra reinvestment income
($78 $69), but the price at which the bond can be sold at the end of the fifth year has
declined from $1,000 to $991, equal to a capital loss of $9. Thus, the gain in reinvestment
income is exactly offset by the capital loss on the sale of the bond.
These examples demonstrate that matching the duration of a coupon bond—
or any other fixed–interest rate instrument, such as a loan or mortgage—to the
FI’s target or investment horizon immunizes the FI against instantaneous shocks to
interest rates. The gains or losses on reinvestment income that result from an interest rate change are exactly offset by losses or gains from the bond proceeds on sale.
Duration and Interest Rate Risk Management
on the Whole Balance Sheet of an FI
duration gap
A measure of overall
interest rate risk exposure for an FI.
So far we have looked at the durations of individual instruments and ways to
select individual fixed-income securities to protect FIs such as life insurance companies and pensions funds with precommitted liabilities such as future pension
plan payouts. The duration model can also evaluate the overall interest rate exposure for an FI, that is, measure the duration gap on its balance sheet.
The Duration Gap for a Financial Institution
To estimate the overall duration gap of an FI, we determine first the duration of
an FI’s asset portfolio (A) and the duration of its liability portfolio (L). These can
be calculated as:
DA X 1 A D1A X 2 A D2A ... X nA DnA
Chapter 9
Interest Rate Risk II
245
and
DL X 1L D1L X 2 L D2L ... X nL DnL
where
X 1 j X 2 j ... X nj 1 and j A, L
The Xij’s in the equation are the market value proportions of each asset or liability held in the respective asset and liability portfolios. Thus, if new 30-year Treasury
bonds were 1 percent of a life insurer’s portfolio and D1A (the duration of those
bonds) was equal to 9.25 years, then X 1 A D1A 0.01(9.25) 0.0925. More simply,
the duration of a portfolio of assets or liabilities is a market value weighted average
of the individual durations of the assets or liabilities on the FI’s balance sheet.
Consider an FI’s simplified market value balance sheet:
Assets ($)
Liabilities ($)
A 100
L 90
E 10
100
100
From the balance sheet:
A LE
and
A L E
or
E A L
That is, when interest rates change, the change in the FI’s equity or net worth (E)
is equal to the difference between the change in the market values of assets and
liabilities on each side of the balance sheet. Since ΔE ΔA ΔL, we need to determine how ΔA and ΔL—the changes in the market values of assets and liabilities on
the balance sheet—are related to duration.
From the duration model (assuming annual compounding of interest):
A
R
DA
(1 R)
A
L
R
DL
(1 R)
L
Here we have simply substituted ΔA/A or ΔL/L, the percentage change in the
market values of assets or liabilities, for ΔP/P, the percentage change in any single
bond’s price and DA or DL, the duration of the FI’s asset or liability portfolio, for
D, the duration on any given bond, deposit, or loan. The term ΔR/(1 R) reflects
the shock to interest rates as before.10 These equations can be rewritten to show the
dollar changes in assets and liabilities on an FI’s balance sheet:
R
(7)
A DA A (1 R)
and
L DL L R
(1 R)
(8)
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Part Two
Measuring Risk
We can substitute these two expressions into the equation ΔE ΔA ΔL.
Rearranging and combining this equation results in a measure of the change in
the market value of equity on an FI’s balance sheet for a change in interest rates:
E [DA DL k ] A R
1R
(9)
where k L/A is a measure of the FI’s leverage, that is, the amount of borrowed
funds or liabilities rather than owners’ equity used to fund its asset portfolio.11
The effect of interest rate changes on the market value of an FI’s equity or net
worth (ΔE) breaks down into three effects:
1. The leverage adjusted duration gap [DA DLk]. This gap is measured in years and
reflects the degree of duration mismatch in an FI’s balance sheet. Specifically, the
larger this gap is in absolute terms, the more exposed the FI is to interest rate shocks.
2. The size of the FI. The term A measures the size of the FI’s assets. The larger the
scale of the FI, the larger the dollar size of the potential net worth exposure
from any given interest rate shock.
3. The size of the interest rate shock ΔR/(1 R). The larger the shock, the greater
the FI’s exposure.
Given this, we express the exposure of the net worth of the FI as:
E [Leverage adjusted duration gap] Asset size Interest rate shock
Interest rate shocks are largely external to the FI and often result from changes
in the Federal Reserve’s monetary policy (as discussed in the first section of
Chapter 8). The size of the duration gap and the size of the FI, however, are under
the control of management.
The Industry Perspectives box reports the duration gaps and the estimated
changes in equity value for three financial institutions during the first quarter of
2012. Note that all three institutions had average duration gaps that were negative
10
We assume that the level of rates and the expected shock to interest rates are the same for both assets
and liabilities, which means that the FI’s spread (the difference between the rate on earning assets and
interest-bearing liabilities) is zero. However, as long as the FI has more earning assets than interest bearing liabilities, it will have a positive level for net interest income. This assumption is standard in Macaulay
duration analysis. While restrictive, this assumption can be relaxed. However, if this is done, the duration
measure changes, as is discussed later in Appendix 9B to this chapter.
11
We do this as follows:
R ⎤
R ⎤
⎡
⎡
⎢ DL L E ⎢ DA A (1 R ) ⎥⎦
(1 R ) ⎥⎦
⎣
⎣
Assuming that the level of rates and the expected shock to interest rates are the same for both assets
and liabilities:
R
E [DA A DLL]
(1 R )
or
E [DA A DLL]
R
(1 R )
To rearrange the equation in a slightly more intuitive fashion, we multiply and divide both DAA and DLL by
A (assets):
A
L⎤
R
⎡
E ⎢ DA
DL ⎥ A A
(1 R )
A⎦
⎣
R
or
E [DA DLk ] A (1 R )
Chapter 9
Interest Rate Risk II
247
or zero. However, Fannie Mae’s duration gaps ranged between 0.9 month and
0.4 month, while Freddie Mac’s ranged between 0.3 month and 0.6 month. Even
these small fluctuations exposed Fannie Mae and Freddie Mac to as much as $200
million and $379 million, respectively, in equity value losses.
Industry Perspectives
Duration GAP for Various Financial
Institutions, March 2012
PRINCIPAL FINANCIAL GROUP
March 31, 2012
Risk Management Strategy
Value of
total assets
Duration
of assets
Net duration
gap
Net fair
value change
Primary duration-managed
Duration-monitored
Non-duration-managed
Total
(in millions)
$26,074.4
25,566.4
5,253.9
$56,894.7
3.73
4.28
4.19
(0.12)
(3.44)
N/A
(in millions)
$31.3
879.9
N/A
$911.2
Net fair value change is based on a 100 basis point
immediate, parallel increase in interest rates increases.
Duration-Managed
Our exposure to interest rate risk stems largely from
our substantial holdings of guaranteed fixed rate
liabilities in our Retirement and Investor Services
segment. We actively manage the duration of assets
and liabilities in these products by minimizing the
difference between the two.
Non-Duration-Managed
We also have a block of participating general
account pension business that passes most of the
actual investment performance of the assets to the
customer. The investment strategy of this block is to
maximize investment return to the customer on a
“best efforts” basis, and there is little or no attempt
to manage the duration of this portfolio since there
is little or no interest rate risk.
Duration-Monitored
For products such as whole life insurance and term
life insurance that are less sensitive to interest rate
risk, and for other products such as individual fixed
deferred annuities, we manage interest rate risk
based on a modeling process that considers the
target average life, maturities, crediting rates, and
assumptions of policyholder behavior.
FANNIE MAE
The duration gap for the three months ended March
31, 2012, averaged zero months, which is similar to
the results for the three months ended March 31,
2011. Rate Slope Shock measures the change in the
value of the equity for the stated change in interest
rates.
For the Three Months Ended March 31, 2012
Duration
Gap
Rate Slope Shock
25 Bps
Rate Level Shock
50 Bps
Exposure
(in months)
Average. . . . . . . . . . . . . . . . . . . . . . . . . . .
Minimum . . . . . . . . . . . . . . . . . . . . . . . . .
Maximum . . . . . . . . . . . . . . . . . . . . . . . . .
Standard deviation. . . . . . . . . . . . . . . . . .
(0.1)
(0.9)
0.4
0.3
(dollars in billions)
$—
—
0.1
—
$—
—
0.2
0.1
continued
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Industry Perspectives
continued
For the Three Months Ended March 31, 2011
Duration
Gap
Rate Slope Shock
25 Bps
Rate Level Shock
50 Bps
Exposure
(in months)
Average. . . . . . . . . . . . . . . . . . . . . . . . . . .
Minimum . . . . . . . . . . . . . . . . . . . . . . . . .
Maximum . . . . . . . . . . . . . . . . . . . . . . . . .
Standard deviation. . . . . . . . . . . . . . . . . .
(dollars in billions)
0.4
(0.4)
0.8
0.2
$0.1
—
0.2
—
$0.2
0.1
0.4
0.1
FREDDIE MAC
Three Months Ended March 31,
2012
Duration
Gap
(in months)
Average. . . . . . . . . . . . . . . . . . . . . .
Minimum . . . . . . . . . . . . . . . . . . . .
Maximum . . . . . . . . . . . . . . . . . . . .
Standard deviation. . . . . . . . . . . . .
0.0
(0.3)
0.6
0.2
* PMVS measures the change in the value of the equity for
the stated change in interest rates.
PMVS*
25 bps
2011
PMVS
50 bps
(dollars in millions)
$16
$ 1
$57
$12
$223
$130
$379
$ 47
Duration
Gap
PMVS
25 bps
PMVS
50 bps
(in months) (dollars in millions)
(0.3)
(1.0)
0.4
0.3
$21
$—
$51
$13
$448
$280
$721
$101
Sources: Principal Financial Group, Form 10-Q, March 31,
2012; Fannie Mae, Form 10-Q, March 31, 2012; Freddie
Mac, Form 10-Q, March 31, 2012.
Equation (9) and the duration model provide an FI manager with a benchmark
measure of the FI’s performance for various interest rate changes and therefore the
extent to which the FI is exposed to interest rate risk. If, for an expected change
in interest rates, managers find the change in equity will be small or negative,
the duration model can be used to identify changes needed on or off the FI’s balance sheet to reduce or even immunize the FI against interest rate risk. Using an
example, the next section explains how a manager can use information on an FI’s
duration gap to restructure the balance sheet to limit losses and even immunize
stockholders’ net worth against interest rate risk (i.e., to set the balance sheet up
before a change in interest rates, so that ΔE is nonnegative for an expected change
in interest rates). Chapters 22, 23, and 24 look at ways a manager can use the duration gap to take off-balance-sheet positions in derivative securities to reduce or
immunize the FI against interest rate risk.
Chapter 9
EXAMPLE 9–9
Duration Gap
Measurement
and Exposure
Interest Rate Risk II
249
Suppose the FI manager calculates that:
DA 5 years
DL 3 years
Then the manager learns from an economic forecasting unit that rates are expected to rise
from 10 percent to 11 percent in the immediate future; that is:
R 1% 0.01
1 R 1.10
The FI’s initial balance sheet is assumed to be:
Assets ($ millions)
Liabilities ($ millions)
A 100
L 90
E 10
100
100
The FI’s manager calculates the potential loss to equity holders’ net worth (E) if the forecast of rising rates proves true as follows:
E ( DA kDL ) A R
(1 R )
(5 (0.9)(3)) $100 million 0.01
$2.09 million
1.10
The FI could lose $2.09 million in net worth if rates rise 1 percent. Since the FI started
with $10 million in equity, the loss of $2.09 million is almost 21 percent of its initial net
worth. The market value balance sheet after the rise in rates by 1 percent would look like
this:12
Assets ($ millions)
Liabilities ($ millions)
A 95.45
L 87.54
E 7.91
95.45
95.45
12
These values are calculated as follows:
A A 5(0.01 1.10) 0.04545 4.545%
100 ( 0.04545)100 95.45
and
L L 3(0.01 1.10) 0.02727 2.727%
90 ( 0.02727)90 87.54
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Even though the rise in interest rates would not push the FI into economic
insolvency, it reduces the FI’s net worth-to-assets ratio from 10 (10/100) to 8.29
(7.91/95.45) percent. To counter this effect, the manager might reduce the FI’s
duration gap. In an extreme case, the gap might be reduced to zero:
E [0] A R (1 R) 0
To do this, the FI should not directly set DA DL, which ignores the fact that the
FI’s assets (A) do not equal its borrowed liabilities (L) and that k (which reflects
the ratio L/A) is not equal to 1. To see the importance of factoring in leverage,
suppose the manager increased the duration of the FI’s liabilities to five years, the
same as DA. Then:
E [5 (0.9)(5)] $100 million (0.01/1.10) $0.45 million
The FI is still exposed to a loss of $0.45 million if rates rise by 1 percent. An appropriate strategy would involve changing DL until:
DA kDL 5 years
For example,
E [5 (0.9) 5.55] $100 million (0.01/1.10) 0
In this case the FI manager sets DL 5.55 years, or slightly longer than DA 5 years,
to compensate for the fact that only 90 percent of assets are funded by borrowed
liabilities, with the other 10 percent funded by equity. Note that the FI manager
has at least three other ways to reduce the duration gap to zero:
1. Reduce DA. Reduce DA from 5 years to 2.7 years [equal to kDL or (0.9)3] such that:
[DA kDL ] [2.7 (0.9)(3)] 0
2. Reduce DA and increase DL. Shorten the duration of assets and lengthen the duration of liabilities at the same time. One possibility would be to reduce DA to 4
years and to increase DL to 4.44 years such that:
[DA kDL ] [4 (0.9)(4.44)] 0
3. Change k and DL. Increase k (leverage) from 0.9 to 0.95 and increase DL from 3
years to 5.26 years such that:
[DA kDL ] [5 (0.95)(5.26)] 0
Concept
Questions
1. Refer to the example of the insurer in Examples 9–6 through 9–8. Suppose rates
fell to 6 percent. Would the FI’s portfolio still be immunized? What if rates rose to
10 percent?
2. How is the overall duration gap for an FI calculated?
3. How can a manager use information on an FI’s duration gap to restructure, and
thereby immunize, the balance sheet against interest rate risk?
4. Suppose DA 3 years, DL 6 years, k 0.8, and A $100 million. What is the
effect on owners’ net worth if ∆R/(1 R) rises 1 percent? (∆E $1,800,000)
Chapter 9
Interest Rate Risk II
251
IMMUNIZATION AND REGULATORY CONSIDERATIONS
In the above section we assumed that the FI manager wants to structure the duration of assets and liabilities to immunize the equity or net worth (E) of the FI’s
equity owners from interest rate shocks. However, regulators periodically monitor the solvency or capital position of FIs. As we discuss in greater detail in Chapter 20 on capital adequacy, regulators set minimum target ratios for an FI’s capital
(or net worth) to assets. The simplest is the ratio of FI capital to its assets, or:
E
Capital (net worth ) ratio
A
www.sec.gov
While this target has normally been formulated in book value accounting terms
for depository institutions, it is evaluated in a market value context for investment
banks. Also, the SEC has long advocated a capital ratio based on market value
accounting for U.S. depository institutions.
Given these regulations imposed on the minimum level of the capital ratio, if
an FI’s asset levels change significantly through time, FI managers may be most
interested in immunizing against changes in the capital ratio (Δ(E/A)) due to
interest rate risk rather than changes in the level of capital (ΔE). For example, suppose the FI manager is close to the minimum regulatory required E/A (or capital)
ratio (e.g., 4.5 percent for depository institutions) and wants to immunize the FI
against any fall in this ratio if interest rates rise.13 That is, the immunization target
is no longer ΔE 0 when rates change but Δ(E/A) 0.
Obviously, immunizing ΔE against interest rate risk cannot result in the same
management strategy as immunizing Δ(E/A). A portfolio constructed to immunize
ΔE would have a different duration match from that required to immunize Δ(E/A).
Or, more simply, the manager could satisfy either the FI’s stockholders or the regulators but not both simultaneously. More specifically, when the objective is to immunize equity capital against interest rate risk, that is, to set ΔE 0, the FI manager
should structure the balance sheet so that the leverage adjusted duration gap is zero:
E 0 DA kDL
or set
DA kDL
By comparison, to immunize the capital ratio, that is, to set Δ(E/A) 0 the manager needs to set:
DA DL
In this scenario, the leverage adjustment effect (k) drops out. If DA 5, then immunizing the capital ratio would require setting DL 5.
Concept
Question
1. Is immunizing a bank’s net worth the same as immunizing its net worth-to-assets
ratio? If not, why not?
13
In actuality, depository institutions face three required minimum capital ratios. The 4.5 percent rule
used in this example is for the common equity capital ratio (see Chapter 20 for more details).
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In the next section, we analyze weaknesses of the duration model. Specifically,
there are several practical problems in estimating duration and duration gap for
real-world FIs.
DIFFICULTIES IN APPLYING THE DURATION MODEL
www.bis.org
Critics of the duration model have often claimed that it is difficult to apply in
real world situations. However, duration measures and immunization strategies
are useful in most real-world situations. In fact, the model used by the Bank for
International Settlements to monitor bank interest rate risk taking is based heavily on the duration model. In this section, we look at the various criticisms of the
duration model and discuss ways that an FI manager would deal with them in
practice. In Appendix 9B to the chapter, we present some of the more advanced
issues associated with these weaknesses.
Duration Matching Can Be Costly
Critics charge that although in principle an FI manager can change DA and DL
to immunize the FI against interest rate risk, restructuring the balance sheet
of a large and complex FI can be both time-consuming and costly. While this
argument may have been true historically, the growth of purchased funds,
asset securitization, and loan sales markets has considerably eased the speed
and lowered the transaction costs of major balance sheet restructurings. (See
Chapters 25 and 26 for a discussion of these strategies.) Moreover, an FI manager
could still manage risk exposure using the duration model by employing techniques other than direct portfolio rebalancing to immunize against interest rate
risk. Managers can get many of the same results of direct duration matching by
taking hedging positions in the markets for derivative securities, such as futures
and forwards (Chapter 22); options, caps, floors, and collars (Chapter 23); and
swaps (Chapter 24).
Immunization Is a Dynamic Problem
Immunization is an aspect of the duration model that is not well understood. Let’s
go back to the earlier immunization example in which an insurer sought to buy
bonds to provide an accumulated cash flow of $1,469 in five years no matter what
happened to interest rates. We showed that buying a six-year maturity, 8 percent
coupon bond with a five-year duration immunizes the insurer against an instantaneous change in interest rates. The word instantaneous is very important here; it
means a change in interest rates immediately after purchasing the bond. However,
interest rates can change at any time over the holding period. Further, the duration of a bond changes as time passes, that is, as it approaches maturity or the
target horizon date. In addition, duration changes at a different rate than does real
or calendar time.
To understand this time effect, consider the initially hedged position in which
the insurer bought the five-year duration (six-year maturity), 8 percent coupon
bond in 2016 to match its cash flow target of $1,469 in 2021. Suppose the FI manager puts the bond in the bottom drawer of a desk and does not think about it for
a year, believing that the insurance company’s position is fully hedged. After one
Chapter 9
Interest Rate Risk II
253
year has passed (in 2017), suppose interest rates (yields) have fallen from 8 percent
to 7 percent and the manager opens the drawer of the desk and finds the bond.
Knowing the target date is now only four years away, the manager recalculates
the duration of the bond. Imagine the manager’s shock on finding that the same
8 percent coupon bond with a 7 percent yield and only five years left to maturity has a duration of 4.33 years. This means the insurance company is no
longer hedged; the 4.33-year duration of this bond portfolio exceeds the investment
horizon of four years. As a result, the manager has to restructure the bond portfolio
to remain immunized. One way to do this is to sell some of the five-year bonds
(4.33-year duration) and buy some bonds of shorter duration so that the overall
duration of the investment portfolio is four years.
For example, suppose the insurer sold 50 percent of the five-year bonds with
a 4.33-year duration and invested the proceeds in 3.67-year duration and maturity zero-coupon bonds. Because duration and maturity are the same for discount
bonds, the duration of the asset portfolio is:
DA [4.33 0.5] [3.67 0.5] 4 years
This simple example demonstrates that immunization based on duration is a
dynamic strategy. In theory, the strategy requires the portfolio manager to rebalance the portfolio continuously to ensure that the duration of the investment
portfolio exactly matches the investment horizon (i.e., the duration of liabilities).
Because continuous rebalancing may not be easy to do and involves costly transaction fees, most portfolio managers seek to be only approximately dynamically
immunized against interest rate changes by rebalancing at discrete intervals,
such as quarterly. That is, there is a trade-off between being perfectly immunized and the transaction costs of maintaining an immunized balance sheet
dynamically.
Large Interest Rate Changes and Convexity
Duration accurately measures the price sensitivity of fixed-income securities for
small changes in interest rates of the order of one basis point. But suppose interest rate shocks are much larger, of the order of 2 percent, or 200 basis points. Then
duration becomes a less accurate predictor of how much the prices of securities
will change and therefore a less accurate measure of interest rate sensitivity. Looking at Figure 9–5, you can see the reason for this. Note first the change in a bond’s
price due to yield changes according to the duration model and second, the true
relationship, as calculated directly, using the exact present value calculation for
bond valuation.
The duration model predicts that the relationship between interest rate shocks
and bond price changes will be proportional to D (duration). However, by precisely calculating the true change in bond prices, we would find that for large
interest rate increases, duration overpredicts the fall in bond prices, while for
large interest rate decreases, it underpredicts the increase in bond prices. That is,
the duration model predicts symmetric effects for rate increases and decreases on
bond prices. As Figure 9–5 shows, in actuality, for rate increases, the capital loss
effect tends to be smaller than the capital gain effect is for rate decreases. This is the
result of the bond price–yield relationship exhibiting a property called convexity
rather than linearity, as assumed by the basic duration model.
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+ ΔP/P
FIGURE 9–5
Duration versus
True Relationship
Error
+
−
0
−D
ΔR
1+R
True relationship
Error
Duration model
−
convexity
The degree of curvature of the price–yield
curve around some
interest rate level.
Note that convexity is a desirable feature for an FI manager to capture in a
portfolio of assets. Buying a bond or a portfolio of assets that exhibits a lot of
convexity, or curvature, in the price–yield curve relationship is similar to buying partial interest rate risk insurance. Specifically, high convexity means that for
equally large changes of interest rates up and down (e.g., plus or minus 2 percent),
the capital gain effect of a rate decrease more than offsets the capital loss effect of a
rate increase. As we show in Appendix 9B to the chapter, all fixed-income assets or
liabilities exhibit some convexity in their price–yield relationships.
To see the importance of accounting for the effects of convexity in assessing the
impact of large rate changes on an FI’s portfolio, consider the six-year Eurobond
with an 8 percent coupon and yield. According to Table 9–2, its duration is
4.993 years, and its current price P0 is $1,000 at a yield of 8 percent:
P0 80
80
80
(1.08)
(1.08)2
(1.08)3
80
80
1, 080
$1, 000
(1.08)4
(1.08)5
(1.08)6
This is point A on the price–yield curve in Figure 9–6.
If rates rise from 8 to 10 percent, the duration model predicts that the bond
price will fall by 9.2463 percent; that is:
P
0.02 ⎤
4.993 ⎡⎢
9.2463%
P
⎣ 1.08 ⎥⎦
or, from a price of $1,000 to $907.537 (see point B in Figure 9–6). However, calculating the exact change in the bond’s price after a rise in yield to 10 percent, we find
that its true value is:
P0 80
80
80
2 (1.10)
(1.10)
(1.10)3
80
80
1, 080
$912.895
(1.10)4
(1.10)5
(1.10)6
Chapter 9
FIGURE 9–6
The Price–Yield
Curve for the SixYear Eurobond
Interest Rate Risk II
255
Price (P)
E
1,098.347
Error
1,092.463
D
A
1,000
912.895
C
907.537
B
6%
8%
10%
Error
Yield (R )
This is point C in Figure 9–6. As you can see, the true or actual fall in price is less
than the predicted fall by $5.358. This means that there is over a 0.5 percent error
using the duration model. The reason for this is the natural convexity to the price–
yield curve as yields rise.
Reversing the experiment reveals that the duration model would predict the
bond’s price to rise by 9.2463 percent if yields fell from 8 to 6 percent, resulting in
a predicted price of $1,092.463 (see point D in Figure 9–6). By comparison, the true
or actual change in price can be computed as $1,098.347 by estimating the present
value of the bond’s coupons and its face value with a 6 percent yield (see point E
in Figure 9–6). The duration model has underpredicted the bond price increase by
$5.884, or by over 0.5 percent of the true price increase.
An important question for the FI manager is whether a 0.5 percent error is big
enough to be concerned about. This depends on the size of the interest rate change
and the size of the portfolio under management. Clearly, 0.5 percent of a large
number will still be a large number!
Summary
This chapter analyzed the duration gap model approach to measuring interest
rate risk. The duration gap model is superior to the simple repricing gap model
in that it incorporates the timing of cash flows as well as maturity effects into a
simple measure of interest rate risk. The duration gap measure could be used to
immunize a particular liability as well as the whole FI balance sheet. However, as
the concluding section of the chapter indicates, a number of potential problems
exist in applying the duration gap model in real-world scenarios. Despite these
weaknesses, the duration gap model is fairly robust and can deal with a large
number of real-world complexities, such as credit risk, convexity, floating interest
rates, and uncertain maturities.
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Questions
and Problems
1. What is the difference between book value accounting and market value
accounting? How do interest rate changes affect the value of bank assets and
liabilities under the two methods? What is marking to market?
2. What are the two different general interpretations of the concept of duration,
and what is the technical definition of this term? How does duration differ
from maturity?
3. A one-year, $100,000 loan carries a coupon rate and a market interest rate of
12 percent. The loan requires payment of accrued interest and one-half of the
principal at the end of six months. The remaining principal and the accrued
interest are due at the end of the year.
a. What will be the cash flows at the end of six months and at the end of the
year?
b. What is the present value of each cash flow discounted at the market rate?
What is the total present value?
c. What proportion of the total present value of cash flows occurs at the end of
six months? What proportion occurs at the end of the year?
d. What is the duration of this loan?
4. Two bonds are available for purchase in the financial markets. The first bond is
a two-year, $1,000 bond that pays an annual coupon of 10 percent. The second
bond is a two-year, $1,000 zero-coupon bond.
a. What is the duration of the coupon bond if the current yield to maturity (R)
is 8 percent? 10 percent? 12 percent? (Hint: You may wish to create a spreadsheet program to assist in the calculations.)
b. How does the change in the yield to maturity affect the duration of this coupon bond?
c. Calculate the duration of the zero-coupon bond with a yield to maturity of 8
percent, 10 percent, and 12 percent.
d. How does the change in the yield to maturity affect the duration of the zero
coupon bond?
e. Why does the change in the yield to maturity affect the coupon bond differently than it affects the zero-coupon bond?
5. What is the duration of a five-year, $1,000 Treasury bond with a 10 percent
semiannual coupon selling at par? Selling with a yield to maturity of
12 percent? 14 percent? What can you conclude about the relationship between
duration and yield to maturity? Plot the relationship. Why does this relationship exist?
6. Consider three Treasury bonds each of which has a 10 percent semiannual coupon and trades at par.
a. Calculate the duration for a bond that has a maturity of four years, three
years, and two years.
b. What conclusions can you reach about the relationship between duration
and the time to maturity? Plot the relationship.
7. A six-year, $10,000 CD pays 6 percent interest annually and has a 6 percent
yield to maturity. What is the duration of the CD? What would be the duration
if interest were paid semiannually? What is the relationship of duration to the
relative frequency of interest payments?
8. What is a consol bond? What is the duration of a consol bond that sells at a
yield to maturity of 8 percent? 10 percent? 12 percent? Would a consol trading
at a yield to maturity of 10 percent have a greater duration than a 20-year zerocoupon bond trading at the same yield to maturity? Why?
Interest Rate Risk II
257
9. Maximum Pension Fund is attempting to manage one of the bond portfolios
under its management. The fund has identified three bonds that have five
year maturities and trade at a yield to maturity of 9 percent. The bonds differ
only in that the coupons are 7 percent, 9 percent, and 11 percent.
a. What is the duration for each bond?
b. What is the relationship between duration and the amount of coupon interest that is paid? Plot the relationship.
10. An insurance company is analyzing three bonds and is using duration as the
measure of interest rate risk. All three bonds trade at a yield to maturity of
10 percent, have $10,000 par values, and have five years to maturity. The
bonds differ only in the amount of annual coupon interest they pay: 8, 10, and
12 percent.
a. What is the duration for each five-year bond?
b. What is the relationship between duration and the amount of coupon interest that is paid?
11. You can obtain a loan of $100,000 at a rate of 10 percent for two years. You
have a choice of (i) paying the interest (10 percent) each year and the total
principal at the end of the second year or (ii) amortizing the loan, that is, paying interest (10 percent) and principal in equal payments each year. The loan is
priced at par.
a. What is the duration of the loan under both methods of payment?
b. Explain the difference in the two results.
12. How is duration related to the interest elasticity of a fixed-income security?
What is the relationship between duration and the price of the fixed-income
security?
13. You have discovered that the price of a bond rose from $975 to $995 when the
yield to maturity fell from 9.75 percent to 9.25 percent. What is the duration of
the bond?
14. A 10-year, 10 percent annual coupon, $1,000 bond trades at a yield to maturity of 8 percent. The bond has a duration of 6.994 years. What is the modified duration of this bond? What is the practical value of calculating modified
duration? Does modified duration change the result of using the duration
relationship to estimate price sensitivity?
15. What is dollar duration? How is dollar duration different from duration?
16. Calculate the duration of a two-year, $1,000 bond that pays an annual coupon
of 10 percent and trades at a yield of 14 percent. What is the expected change
in the price of the bond if interest rates fall by 0.50 percent (50 basis points)?
17. The duration of an 11-year, $1,000 Treasury bond paying a 10 percent semiannual coupon and selling at par has been estimated at 6.763 years.
a. What is the modified duration of the bond? What is the dollar duration of
the bond?
b. What will be the estimated price change on the bond if interest rates
increase 0.10 percent (10 basis points)? If rates decrease 0.20 percent (20
basis points)?
c. What would the actual price of the bond be under each rate change situation in part (b) using the traditional present value bond pricing techniques?
What is the amount of error in each case?
18. Suppose you purchase a six-year, 8 percent coupon bond (paid annually) that
is priced to yield 9 percent. The face value of the bond is $1,000.
a. Show that the duration of this bond is equal to five years.
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19.
20.
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21.
22.
23.
b. Show that if interest rates rise to 10 percent within the next year and your
investment horizon is five years from today, you will still earn a 9 percent
yield on your investment.
c. Show that a 9 percent yield also will be earned if interest rates fall next year
to 8 percent.
Suppose you purchase a five-year, 15 percent coupon bond (paid annually)
that is priced to yield 9 percent. The face value of the bond is $1,000.
a. Show that the duration of this bond is equal to four years.
b. Show that if interest rates rise to 10 percent within the next year and your
investment horizon is four years from today, you will still earn a 9 percent
yield on your investment.
c. Show that a 9 percent yield also will be earned if interest rates fall next year
to 8 percent.
Consider the case in which an investor holds a bond for a period of time
longer than the duration of the bond, that is, longer than the original investment horizon.
a. If interest rates rise, will the return that is earned exceed or fall short of the
original required rate of return? Explain.
b. What will happen to the realized return if interest rates decrease? Explain.
c. Recalculate parts (b) and (c) of problem 19 above, assuming that the bond
is held for all five years, to verify your answers to parts (a) and (b) of this
problem.
d. If either calculation in part (c) is greater than the original required rate of
return, why would an investor ever try to match the duration of an asset
with his or her investment horizon?
Two banks are being examined by regulators to determine the interest rate sensitivity of their balance sheets. Bank A has assets composed solely of a 10-year
$1 million loan with a coupon rate and yield of 12 percent. The loan is financed
with a 10-year $1 million CD with a coupon rate and yield of 10 percent.
Bank B has assets composed solely of a 7-year, 12 percent zero-coupon bond
with a current (market) value of $894,006.20 and a maturity (principal) value
of $1,976,362.88. The bond is financed with a 10-year, 8.275 percent coupon
$1,000,000 face value CD with a yield to maturity of 10 percent. The loan and
the CDs pay interest annually, with principal due at maturity.
a. If market interest rates increase 1 percent (100 basis points), how do the
market values of the assets and liabilities of each bank change? That is,
what will be the net effect on the market value of the equity for each
bank?
b. What accounts for the differences in the changes in the market value of
equity between the two banks?
c. Verify your results above by calculating the duration for the assets and
liabilities of each bank, and estimate the changes in value for the expected
change in interest rates. Summarize your results.
If an FI uses only duration to immunize its portfolio, what three factors affect
changes in the net worth of the FI when interest rates change?
Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent
semiannual coupon Treasury bond selling at par. The duration of this bond has
been estimated at 9.94 years. The assets are financed with equity and a $900,000,
two-year, 7.25 percent semiannual coupon capital note selling at par.
a. What is the leverage adjusted duration gap of Financial Institution XY?
Chapter 9
Interest Rate Risk II
259
b. What is the impact on equity value if the relative change in all market interest rates is a decrease of 20 basis points? Note: The relative change in interest rates is ΔR/(1 R/2) 0.0020.
c. Using the information in parts (a) and (b), what can be said about the
desired duration gap for the financial institution if interest rates are
expected to increase or decrease.
d. Verify your answer to part (c) by calculating the change in the market value
of equity assuming that the relative change in all market interest rates is an
increase of 30 basis points.
e. What would the duration of the assets need to be to immunize the equity
from changes in market interest rates?
24. The balance sheet for Gotbucks Bank Inc. (GBI) is presented below ($ millions).
Assets
Liabilities and Equity
Cash
Federal funds
Loans (floating)
Loans (fixed)
$ 30
20
105
65
Core deposits
Federal funds
Euro CDs
Equity
$ 20
50
130
20
Total assets
$220
Total liabilities and equity
$220
a. What is the duration of the fixed-rate loan portfolio of Gotbucks Bank?
b. If the duration of the floating-rate loans and fed funds is 0.36 year, what is
the duration of GBI’s assets?
c. What is the duration of the core deposits if they are priced at par?
d. If the duration of the Euro CDs and fed funds liabilities is 0.401 year, what
is the duration of GBI’s liabilities?
e. What is GBI’s duration gap? What is its interest rate risk exposure?
f. What is the impact on the market value of equity if the relative change in
all interest rates is an increase of 1 percent (100 basis points)? Note that the
relative change in interest rates is ΔR/(1 R) 0.01.
g. What is the impact on the market value of equity if the relative change in
all interest rates is a decrease of 0.5 percent (50 basis points)?
h. What variables are available to GBI to immunize the bank? How much
would each variable need to change to get DGAP to equal zero?
25. Hands Insurance Company issued a $90 million, one-year note at 8 percent
add-on annual interest (paying one coupon at the end of the year) or with
an 8 percent yield. The proceeds were used to fund a $100 million, two-year
commercial loan with a 10 percent coupon rate and a 10 percent yield. Immediately after these transactions were simultaneously closed, all market interest
rates increased 1.5 percent (150 basis points).
a. What is the true market value of the loan investment and the liability after
the change in interest rates?
b. What impact did these changes in market value have on the market value
of the FI’s equity?
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Notes to the balance sheet: The fed funds rate is 8.5 percent, the floating loan rate is LIBOR 4
percent, and currently LIBOR is 11 percent. Fixed-rate loans have five-year maturities, are priced
at par, and pay 12 percent annual interest. The principal is repaid at maturity. Core deposits are
fixed rate for two years at 8 percent paid annually. The principal is repaid at maturity. Euro CDs
currently yield 9 percent.
260
Part Two
Measuring Risk
c. What was the duration of the loan investment and the liability at the time
of issuance?
d. Use these duration values to calculate the expected change in the value of the
loan and the liability for the predicted increase of 1.5 percent in interest rates.
e. What is the duration gap of Hands Insurance Company after the issuance
of the asset and note?
f. What is the change in equity value forecasted by this duration gap for the
predicted increase in interest rates of 1.5 percent?
g. If the interest rate prediction had been available during the time period in
which the loan and the liability were being negotiated, what suggestions
would you have offered to reduce the possible effect on the equity of the
company? What are the difficulties in implementing your ideas?
26. The following balance sheet information is available (amounts in thousands
of dollars and duration in years) for a financial institution:
Amount
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T-bills
T-notes
T-bonds
Loans
Deposits
Federal funds
Equity
$
90
55
176
2,724
2,092
238
715
Duration
0.50
0.90
x
7.00
1.00
0.01
Treasury bonds are five-year maturities paying 6 percent semiannually and
selling at par.
a. What is the duration of the T-bond portfolio?
b. What is the average duration of all the assets?
c. What is the average duration of all the liabilities?
d. What is the leverage adjusted duration gap? What is the interest rate risk
exposure?
e. What is the forecasted impact on the market value of equity caused
by a relative upward shift in the entire yield curve of 0.5 percent [i.e.,
ΔR/(1 R) 0.0050]?
f. If the yield curve shifts downward 0.25 percent [i.e., ΔR/(1 R) 0.0025],
what is the forecasted impact on the market value of equity?
g. What variables are available to the financial institution to immunize the
balance sheet? How much would each variable need to change to get
DGAP to equal 0?
27. Assume that a goal of the regulatory agencies of financial institutions is to
immunize the ratio of equity to total assets, that is, Δ(E/A) 0. Explain how
this goal changes the desired duration gap for the institution. Why does this
differ from the duration gap necessary to immunize the total equity? How
would your answers to part (h) in problem 24 and part (g) in problem 26
change if immunizing equity to total assets was the goal?
28. Identify and discuss three criticisms of using the duration gap model to immunize the portfolio of a financial institution.
29. In general, what changes have occurred in the financial markets that would
allow financial institutions to restructure their balance sheets more rapidly
and efficiently to meet desired goals? Why is it critical for an FI manager who
Chapter 9
Interest Rate Risk II
261
has a portfolio immunized to match a desired investment horizon to rebalance
the portfolio periodically? What is convexity? Why is convexity a desirable
feature to capture in a portfolio of assets?
30. A financial institution has an investment horizon of two years 9.33 months
(or 2.777 years). The institution has converted all assets into a portfolio of
8 percent, $1,000 three-year bonds that are trading at a yield to maturity of
10 percent. The bonds pay interest annually. The portfolio manager believes
that the assets are immunized against interest rate changes.
a. Is the portfolio immunized at the time of the bond purchase? What is the
duration of the bonds?
b. Will the portfolio be immunized one year later?
c. Assume that one-year, 8 percent zero-coupon bonds are available in one
year. What proportion of the original portfolio should be placed in these
bonds to rebalance the portfolio?
The following questions and problems are based on material in Appendix 9A,
at the book’s website (www.mhhe.com/saunders8e).
Change
N
Coupon
Rate
8
9
10%
10
YTM
9%
9
10
10
10
10
10
10
9
10
11
11
12
10
10
11
11
Price
$ Change in Price
from Par
% Change in
Price from Par
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31. Consider a 12-year, 12 percent annual coupon bond with a required return of
10 percent. The bond has a face value of $1,000.
a. What is the price of the bond?
b. If interest rates rise to 11 percent, what is the price of the bond?
c. What has been the percentage change in price?
d. Repeat parts (a), (b), and (c) for a 16-year bond.
e. What do the respective changes in bond prices indicate?
32. Consider a five-year, 15 percent annual coupon bond with a face value of
$1,000. The bond is trading at a yield to maturity of 12 percent.
a. What is the price of the bond?
b. If the yield to maturity increases 1 percent, what will be the bond’s new price?
c. Using your answers to parts (a) and (b), what is the percentage change in
the bond’s price as a result of the 1 percent increase in interest rates?
d. Repeat parts (b) and (c) assuming a 1 percent decrease in interest rates.
e. What do the differences in your answers indicate about the interest rate–
price relationships of fixed-rate assets?
33. Consider a $1,000 bond with a fixed-rate 10 percent annual coupon rate and a
maturity (N) of 10 years. The bond currently is trading at a yield to maturity
(YTM) of 10 percent.
a. Complete the following table:
262
Part Two
Measuring Risk
b. Use this information to verify the principles of interest rate–price relationships for fixed-rate financial assets.
Rule 1. Interest rates and prices of fixed-rate financial assets move inversely.
Rule 2. The longer is the maturity of a fixed-income financial asset, the greater
is the change in price for a given change in interest rates.
Rule 3. The change in value of longer-term fixed-rate financial assets increases
at a decreasing rate.
Rule 4. Although not mentioned in Appendix 9A, for a given percentage ( )
change in interest rates, the increase in price for a decrease in rates is greater
than the decrease in value for an increase in rates.
The following questions and problems are based on material in Appendix 9B
to the chapter.
34. MLK Bank has an asset portfolio that consists of $100 million of 30-year,
8 percent coupon, $1,000 bonds that sell at par.
a. What will be the bonds’ new prices if market yields change immediately
by / 0.10 percent? What will be the new prices if market yields change
immediately by / 2.00 percent?
b. The duration of these bonds is 12.1608 years. What are the predicted bond
prices in each of the four cases using the duration rule? What is the amount
of error between the duration prediction and the actual market values?
c. Given that convexity is 212.4, what are the bond price predictions in each
of the four cases using the duration plus convexity relationship? What is
the amount of error in these predictions?
d. Diagram and label clearly the results in parts (a), (b), and (c).
35. Estimate the convexity for each of the following three bonds, all of which
trade at a yield to maturity of 8 percent and have face values of $1,000.
A 7-year, zero-coupon bond.
A 7-year, 10 percent annual coupon bond.
A 10-year, 10 percent annual coupon bond that has a duration value of 6.994
years (i.e., approximately 7 years).
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Rank the bonds in terms of convexity, and express the convexity relationship
between zeros and coupon bonds in terms of maturity and duration equivalencies.
Integrated Mini Case
CALCULATING AND USING DURATION GAP
State Bank’s balance sheet is listed below. Market yields and durations (in years) are in parenthesis, and
amounts are in millions.
Assets
Cash
Fed funds (5.05%, 0.02)
T-bills (5.25%, 0.22)
T-bonds (7.50%, 7.55)
Liabilities and Equity
$
20
150
300
200
Demand deposits
MMDAs (4.5%, 0.50)
(no minimum balance requirement)
CDs (4.3%, 0.48)
$ 250
360
715
Chapter 9
Assets
Interest Rate Risk II
263
Liabilities and Equity
900
475
1,200
Consumer loans (6%, 2.50)
C&I loans (5.8%, 6.58)
Fixed-rate mortgages (7.85%, 19.50)
Variable-rate mortgages,
repriced @ quarter (6.3%, 0.25)
Premises and equipment
580
120
Total assets
$3,945
a. What is State Bank’s duration gap?
b. Use these duration values to calculate the
expected change in the value of the assets and
liabilities of State Bank for a predicted increase
of 1.5 percent in interest rates.
CDs (6%, 4.45)
Fed funds (5%, 0.02)
Commercial paper (5.05%, 0.45)
Subordinated debt:
Fixed-rate (7.25%, 6.65)
Total liabilities
Equity
Total liabilities and equity
1,105
515
400
200
$3,545
400
$3,945
c. What is the change in equity value forecasted
from the duration values for a predicted increase
in interest rates of 1.5 percent?
Integrated Mini Case: Chapters 8 and 9
CALCULATING AND USING REPRICING AND DURATION GAP
State Bank’s balance sheet is listed below. Market yields and durations (in years) are in parenthesis, and
amounts are in millions.
Cash
Fed funds (2.05%, 0.02)
3-month T-bills (3.25%, 0.22)
8-year T-bonds (6.50%, 7.55)
5-year munis (7.20%, 4.25)
6-month consumer loans (5%, 0.42)
5-year car loans (6%, 3.78)
7-month C&I loans (4.8%, 0.55)
2-year C&I loans (4.15%, 1.65)
Fixed-rate mortgages (5.10%, 0.48) (maturing
in 5 months)
Fixed-rate mortgages (6.85%, 0.85) (maturing
in 1 year)
Fixed-rate mortgages (5.30%, 4.45) (maturing
in 5 years)
Fixed-rate mortgages (5.40%, 18.25) (maturing
in 20 years)
Premises and equipment
Total assets
Liabilities and Equity
$
31
150
200
250
50
250
350
200
275
450
300
275
355
20
$3,156
$ 253
50
Demand deposits
Savings accounts (0.5%, 1.25)
MMDAs (3.5%, 0.50)
(no minimum balance requirement)
3-month CDs (3.2%, 0.20)
1-year CDs (3.5%, 0.95)
5-year CDs (5%, 4.85)
Fed funds (2%, 0.02)
Repos (2%, 0.05)
6-month commercial paper
(4.05%, 0.55)
Subordinate notes:
1-year fixed rate (5.55%, 0.92)
Subordinated debt:
7-year fixed rate (6.25%, 6.65)
Total liabilities
$2,778
Equity
Total liabilities and equity
3078
$3,156
460
175
375
350
225
290
300
200
100
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Assets
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264
Part Two
Measuring Risk
a. What is State Bank’s repricing gap if the planning period is six months? one year?
b. What is State Bank’s duration gap?
c. What is the impact over the next six months
on net interest income if interest rates on RSAs
increase 50 basis points and on RSLs increase
35 basis points? Explain the results.
d. What is the impact over the next year on net
interest income if interest rates on RSAs decrease
(increase) 35 basis points and on RSLs decrease
(increase) 50 basis points? Explain the results.
e. Use these duration values to calculate the
expected change in the value of the assets and
liabilities of State Bank for a predicted decrease
of 0.35 percent in interest rates on assets and
0.50 percent on liabilities.
f. What is the change in equity value forecasted
from the duration values for decrease of
0.35 percent in interest rates on assets and
0.50 percent on liabilities?
g. Use the duration gap model to calculate the
change in equity value if the relative change in
all market interest rates is a decrease of 50 basis
points.
Appendix 9A: The Basics of Bond Valuation
View Appendix 9A at the website for this textbook (www.mhhe.com/saunders8e).
Appendix 9B
Incorporating Convexity into the Duration Model
In the main body of the chapter, we established
these three characteristics of convexity:
1. Convexity is desirable. The greater the convexity of a security or a portfolio of securities, the
more insurance or interest rate protection an FI
manager has against interest rate increases and
the greater the potential gains after interest rate
decreases.
2. Convexity and duration. The larger the interest rate changes and the more convex a fixed
income security or portfolio, the greater the
error the FI manager faces in using just duration (and duration matching) to immunize
exposure to interest rate shocks.
3. All fixed-income securities are convex.1 To see this,
we can take the six-year, 8 percent coupon,
8 percent yield bond and look at two extreme
price–yield scenarios. What is the price on the
1
This applies to fixed-income securities without special option
features such as calls and puts.
bond if yields falls to zero, and what is its price
if yields rise to some very large number, such as
infinity?
When R 0:
P 80
1, 080
... $1, 480
(1 0)
(1 0)6
The price is just the simple undiscounted sum
of the coupon values and the face value. Since
yields can never go below zero, $1,480 is the maximum possible price for the bond.
When R :
P 80
1, 080
... ⯝ 0
(1 + ∞)
(1 + ∞)6
As the yield goes to infinity, the bond price falls
asymptotically toward zero, but by definition a
bond’s price can never be negative. Thus, zero must
be the minimum bond price (see Figure 9B–1).
Chapter 9
FIGURE 9B–1
Price
The Natural
Convexity of Bonds
1,480
Interest Rate Risk II
265
Price–yield curve convexity
∞ Yield (R )
0
Since convexity is a desirable feature for assets,
the FI manager might ask: Can we measure convexity? And can we incorporate this measurement in the duration model to adjust for or offset
the error in prediction due to its presence? The
answer to both questions is yes.
Theoretically speaking, duration is the slope
of the price–yield curve, and convexity, or curvature, is the change in the slope of the price–yield
curve. Consider the total effect of a change in
interest rates on a bond’s price as being broken
into a number of separate effects. The precise
mathematical derivation of these separate effects
is based on a Taylor series expansion that you
might remember from your math classes. Essentially, the first-order effect (dP/dR) of an interest
rate change on the bond’s price is the price–yield
curve slope effect, which is measured by duration. The second-order effect (dP2/d2R) measures
the change in the slope of the price–yield curve.
This is the curvature, or convexity, effect. There
are also third-, fourth-, and higher-order effects
from the Taylor series expansion, but for all practical purposes these effects can be ignored.
We have noted that overlooking the curvature
of the price–yield curve may cause errors in predicting the interest rate sensitivity of a portfolio
of assets and liabilities, especially when yields
change by large amounts. We can adjust for this
by explicitly recognizing the second-order effect
of yield changes by measuring the change in the
slope of the price–yield curve around a given
point. Just as D (duration) measures the slope
effect (dP/dR), we introduce a new parameter
(CX) to measure the curvature effect (dP2/d2R) of
the price–yield curve.
The resulting equation, predicting the change
in a security’s price (ΔP/P), is:
P
1
R
D
CX ( R)2
P
(1 R)
2
(1)
or:
P
1
MD R CX ( R)2
P
2
(2)
The first term in equation (1) is the simple
duration model that over- or underpredicts price
changes for large changes in interest rates. The
second term is the second-order effect of interest
rate changes, that is, the convexity or curvature
adjustment. In equation (1), the first term D can
be divided by 1 R to produce what we called
earlier modified duration (MD). You can see
this in equation (2). In the convexity term, the
number 1/2 and (ΔR)2 result from the fact that
the convexity effect is the second-order effect
of interest rate changes, while duration is the
first-order effect. The parameter CX reflects the
degree of curvature in the price–yield curve
at the current yield level; that is, the degree to
which the capital gain effect exceeds the capital
loss effect for an equal change in yields up or
down. At best, the FI manager can only approximate the curvature effect by using a parametric
measure of CX. Even though calculus is based
on infinitesimally small changes, in financial
markets the smallest change in yields normally
observed is one basis point, or a 1/100th of 1
percent change. One possible way to measure
CX is introduced next.
As just discussed, the convexity effect is the
degree to which the capital gain effect more than
offsets the capital loss effect for an equal increase
and decrease in interest rates at the current interest rate level. In Figure 9B–2 we depict yields
changing upward by one basis point (R 0.01%)
and downward by one basis point (R 0.01%).
Because convexity measures the curvature of the
price–yield curve around the rate level R percent,
it intuitively measures the degree to which the
capital gain effect of a small yield decrease exceeds
266
Part Two
Measuring Risk
FIGURE 9B–2
Price
Convexity and the
Price–Yield Curve
P+
Capital
gain
P
Capital
loss
P–
R –0.01% R %
the capital loss effect of a small yield increase.
Definitionally, the CX parameter equals:
⎡ Capital
Capital
⎢
gain from a
⎢ loss from a
Scaling ⎢ one-basis-point
one-basis-point
CX factor ⎢
⎢ rise in yield
fall in yield
⎢
(negative
effect)
(positive effect)
⎢⎣
⎤
⎥
⎥
⎥
⎥
⎥
⎥
⎥⎦
The sum of the two terms in the brackets
reflects the degree to which the capital gain effect
exceeds the capital loss effect for a small onebasis-point interest rate change down and up. The
scaling factor normalizes this measure to account
for a larger 1 percent change in rates. Remember,
when interest rates change by a large amount, the
convexity effect is important to measure. A commonly used scaling factor is 108 so that:2
⎡ P
CX 108 ⎢
⎣ P
P ⎤
P ⎥⎦
Calculation of CX
To calculate the convexity of the 8 percent coupon, 8 percent yield, six-year maturity Eurobond
that had a price of $1,000:3
2
This is consistent with the effect of a 1 percent (100 basis
points) change in rates.
3
You can easily check that $999.53785 is the price of the sixyear bond when rates are 8.01 percent and $1,000.46243 is the
price of the bond when rates fall to 7.99 percent. Since we are
dealing in small numbers and convexity is sensitive to the number
of decimal places assumed, we use at least five decimal places
in calculating the capital gain or loss. In fact, the more decimal
places used, the greater the accuracy of the CX measure.
R +0.01%
CX 10
8
Yield
⎡ 999.53785 ⎢⎣
1, 000
Capital loss from
a one-basis-point
increase in rates
1, 000
1, 000.46243 1, 000 ⎤
1, 000
⎥⎦
Capital gain from
a one-basis-point
decrease in rates
8
CX 10 [0.00000028]
CX 28
This value for CX can be inserted into the bond
price prediction equation (2) with the convexity
adjustment:
P
1
MD R (28) R 2
P
2
Assuming a 2 percent increase in R (from 8 to
10 percent),
4.993 ⎤
P
1
⎡⎢
0.02 (28)(0.02)2
P
2
⎣ 1.08 ⎥⎦
0.0925 0.0056
0.0869 or 8.69%
The simple duration model (the first term)
predicts that a 2 percent rise in interest rates will
cause the bond’s price to fall 9.25 percent. However, for large changes in yields, the duration
model overpredicts the price fall. The duration
model with the second-order convexity adjustment predicts a price fall of 8.69 percent; it adds
back 0.56 percent because of the convexity effect.
This is much closer to the true fall in the six-year,
8 percent coupon bond’s price if we calculate this
using 10 percent to discount the coupon and face
value cash flows on the bond. The true value of
Chapter 9
Interest Rate Risk II
267
TABLE 9B–1 Properties of Convexity
2. Convexity Varies
with Coupon
1. Convexity Increases with Bond Maturity
Example
Example
Example
A
B
C
A
B
A
B
N6
R 8%
C 8%
D5
CX 28
N 18
R 8%
C 8%
D 10.12
CX 130
N
R 8%
C 8%
D 13.5
CX 312
N6
R 8%
C 8%
D5
CX 28
N6
R 8%
C 0%
D6
CX 36
N6
R 8%
C 8%
D5
CX 28
N5
R 8%
C 0%
D5
CX 25.72
the bond price fall is 8.71 percent. That is, using
the convexity adjustment reduces the error
between predicted value and true value to just a
few basis points.4
In Table 9B–1 we calculate various properties
of convexity, where
N Time to maturity
R Yield to maturity
C Annual coupon
D Duration
CX Convexity
Part 1 of Table 9B–1 shows that as the bond’s
maturity (N) increases, so does its convexity (CX).
As a result, long-term bonds have more convexity—
which is a desirable property—than do short-term
bonds. This property is similar to that possessed by
duration.5
Part 2 of Table 9B–1 shows that coupon bonds of
the same maturity (N) have less convexity than do
zero-coupon bonds. However, for coupon bonds
4
3. Same Duration,
Zero-Coupon Bonds
Are Less Convex
Than Coupon Bonds
It is possible to use the third moment of the Taylor series
expansion to reduce this small error (8.71 percent versus
8.69 percent) even further. In practice, few FIs do this.
5
Note that the CX measure differs according to the level of
interest rates. For example, we are measuring CX in Table 9B–1
when yields are 8 percent. If yields were 12 percent, the CX
number would change. This is intuitively reasonable, as the
curvature of the price–yield curve differs at each point on the
price–yield curve. Note that duration also changes with the level
of interest rates.
and discount or zero-coupon bonds of the same
duration, part 3 of the table shows that the coupon
bond has more convexity. We depict the convexity
of both in Figure 9B–3.
Finally, before leaving convexity, we might
look at one important use of the concept by managers of insurance companies, pension funds, and
mutual funds. Remembering that convexity is a
desirable form of interest rate risk insurance, FI
managers could structure an asset portfolio to
maximize its desirable effects. Consider a pension fund manager with a 15-year payout horizon. To immunize the risk of interest rate changes,
the manager purchases bonds with a 15-year
duration. Consider two alternative strategies to
achieve this:
Strategy 1: Invest 100 percent of resources in a
15-year deep-discount bond with
an 8 percent yield.
Strategy 2: Invest 50 percent in the very shortterm money market (Federal funds)6
and 50 percent in 30-year deepdiscount bonds with an 8 percent
yield.
The duration (D) and convexities (CX) of these
two asset portfolios are:
Strategy 1: D 15, CX 206
Strategy 2: D ½(0) ½(30) 15,
CX ½(0) ½(797) 398.5
6
The duration and convexity of one-day federal funds are
approximately zero.
268
Part Two
Measuring Risk
+ ΔP/P
FIGURE 9B–3
Convexity of a
Coupon versus a
Discount Bond with
the Same Duration
–
–MD = –D
1+R
0
+
ΔR
Coupon bond
= –4.62
Discount bond
–
Strategies 1 and 2 have the same durations,
but strategy 2 has a greater convexity. Strategy
2 is often called a barbell portfolio, as shown in
Figure 9B–4 by the shaded bars.7 Strategy 1 is the
unshaded bar. To the extent that the market does
not price (or fully price) convexity, the barbell
strategy dominates the direct duration-matching
strategy (strategy 1).8
More commonly, an FI manager may seek to
attain greater convexity in the asset portfolio than
in the liability portfolio, as shown in Figure 9B–5.
As a result, both positive and negative shocks to
interest rates would have beneficial effects on the
FI’s net worth.9
7
This is called a barbell because the weights are equally loaded
at the extreme ends of the duration range, or bar, as in weight
lifting.
8
In a world in which convexity is priced, the long-term 30-year
bond’s price would rise to reflect the competition among buyers
to include this more convex bond in their barbell asset portfolios. Thus, buying bond insurance—in the form of the barbell
portfolio—would involve an additional cost to the FI manager.
In addition, for the FI to be hedged in both a duration sense
and a convexity sense, the manager should not choose the convexity of the asset portfolio without seeking to match it to the
convexity of the liability portfolio.
9
Another strategy would be for the FI to issue callable bonds
as liabilities. Callable bonds have limited upside capital gains
because if rates fall to a low level, then the issuer calls the
bond in early (and reissues new lower coupon bonds). The
effect of limited upside potential for callable bond prices is
that the price–yield curve for such bonds exhibits negative
convexity. Thus, if asset investments have positive convexity
and liabilities negative convexity, then yield shocks (whether
positive or negative) are likely to produce net worth gains
for the FI.
THE PROBLEM OF THE FLAT
TERM STRUCTURE
We have been calculating the simple, or Macaulay, duration. A key assumption of the simple
duration model is that the yield curve or term
structure of interest rates is flat and that when
rates change, the yield curve shifts in a parallel
fashion.
In the real world, the yield curve can take many
shapes and at best may only approximate a flat
yield curve. If the yield curve is not flat, using simple duration could be a potential source of error
in predicting asset and liability interest rate sensitivities. Many models can deal with this problem.
These models differ according to the shapes and
shocks to the yield curve that are assumed.
Suppose the yield curve is not flat but shifts in
such a manner that the yields on different maturity discount bonds change in a proportional
fashion.10 Consider calculating the duration of
the six-year Eurobond when the yield curve is
not flat at 8 percent. Instead, the yield curve looks
like the one in Figure 9B–6.
Suppose the yield on one-year discount bonds
rises. Assume also that the discounted changes
in longer-maturity discount bond yields are just
10
We are interested in the yield curve on discount bonds
because these yields reflect the time value of money for
single payments at different maturity dates. Thus, we can use
these yields as discount rates for cash flows on a security to
calculate appropriate present values of its cash flows and its
duration.
Chapter 9
FIGURE 9B–4
Interest Rate Risk II
Percent of portfolio
Barbell Strategy
100
50
0
FIGURE 9B–5
Assets Are More
Convex Than
Liabilities
Asset,
liability,
equity
value ($)
15
30
Equity
{
} Equity
R22%
FIGURE 9B–6
Nonflat Yield Curve
Duration
R%
} Equity
R +2%
Assets
Liabilities
Interest rates
Discount bond
yield curve
Yield (%)
10.3
10.2
9.8
9.4
8.8
8.0
0
1
2
3
4
5
6
Maturity
269
270
Part Two
Measuring Risk
TABLE 9B–2
Duration with an
Upward-Sloping
Yield Curve
t
CF
CF ⴛ DF
DF
CF ⴛ DF ⴛ t
1
80
1
0.9259
(1.08)
74.07
74. 07
2
80
1
0.8448
(1.088)2
67.58
135.16
3
80
1
0.7637
(1.094)3
61.10
183.30
4
80
1
0.6880
(1.098)4
55.04
220.16
5
80
1
0.6153
(1.102)5
49.22
246.10
6
1,080
1
0.5553
(1.103)6
599.75
3,598.50
906.76
4,457.29
D* proportional to the change in the one-year discount bond yield:
R6
R1
R2
... 1 R1
1 R2
1 R6
Given this quite restrictive assumption, it can
be proved that the appropriate duration measure
of the bond—call it D*—can be derived by discounting the coupons and principal value of the
bond by the discount rates or yields on appropriate maturity zero-coupon bonds. Given the discount bond yield curve plotted in Figure 9B–6, D*
is calculated in Table 9B–2.
Notice that D* is 4.916 years, while the simple
Macaulay duration (with an assumed flat 8 percent
yield curve) is 4.993 years. D* and D differ because,
by taking into account the upward-sloping yield
curve in Figure 9B–6, the later cash flows are discounted at higher rates than they are under the flat
yield curve assumption underlying Macaulay’s
measure D.
With respect to the FI manager’s problem, choosing to use D* instead of D does not change the basic
problem except for a concern with the gap between
the D* on assets and leverage-weighted liabilities:
4, 457.29
4.91562
906.76
DA* kDL*
However, remember that the D* was calculated
under very restrictive assumptions about the
yield curve. If we change these assumptions in
any way, the measure of D* changes.
THE PROBLEM OF DEFAULT RISK
The models and the duration calculations we have
looked at assume that the issuer of bonds or the
borrower of a loan pays the promised interest and
principal with a probabilitity of 1; we assume no
default or delay in the payment of cash flows. In
the real world, problems with principal and interest payments are common and lead to restructuring and workouts on debt contracts as bankers and
bond trustees renegotiate with borrowers; that is,
the borrower reschedules or recontracts interest
and principal payments rather than defaulting
outright. If we view default risk as synonymous
with the rescheduling of cash flows to a later date,
this is quite easy to deal with in duration models.
Consider the six-year, 8 percent coupon,
8 percent yield Eurobond. Suppose the issuer gets
into difficulty and cannot pay the first coupon.
Instead, the borrower and the FI agree that the
Chapter 9
TABLE 9B–3
Duration and
Rescheduling
t
CF
DF
CF ⴛ DF
CF ⴛ DF ⴛ t
1
2
3
4
5
6
0
160
80
80
80
1,080
0.9259
0.8573
0.7938
0.7350
0.6806
0.6302
0
137.17
63.51
58.80
54.45
680.58
994.51
0
274.34
190.53
235.21
272.25
4,083.48
5,055.81
D unpaid interest can be paid in year 2. This alleviates part of the cash flow pressure on the borrower
while lengthening the duration of the bond from
the FI’s perspective (see Table 9B–3). The effect of
rescheduling the first interest payment is to increase
duration from approximately 5 years to 5.08 years.
More commonly, an FI manager unsure of the
future cash flows because of future default risk
might multiply the promised cash flow (CFt) by
the probability of repayment (pt) in year t to generate expected cash flows in year t—E(CFt).
E(CFt ) pt CFt
Chapter 10 suggests a number of ways to generate these repayment probabilities. Once the
cash flows have been adjusted for default risk,
a duration measure can be directly calculated in
the same manner as the Macaulay formula (or D*)
except that E(CFt) replaces CFt.11
FLOATING-RATE LOANS
AND BONDS
The duration models we have looked at assume
that the interest rates on loans or the coupons on
bonds are fixed at issue and remain unchanged
until maturity. However, many bonds and loans
carry floating interest rates. Examples include
loan rates indexed to LIBOR (London Interbank
11
Interest Rate Risk II
Alternatively, the promised cash flow could be discounted by
the appropriate discount yield on a risk-free Treasury security plus
an appropriate credit-risk spread; that is, CFt /(1 dt St)t, where
CFt is the promised cash flow in year t, dt is the yield on a t-period
zero-coupon Treasury bond, and St is a credit-risk premium.
5,055.81
994.51
271
5.0837 years
Offered Rate) and adjustable-rate mortgages
(ARMs) whose rates can be indexed to Treasury
or other securities yields. Moreover, in the 1980s,
many banks and security firms either issued or
underwrote perpetual floating-rate notes (FRNs).
These are like consol bonds in that they never
mature. Unlike consols, their coupons fluctuate
with market rates. The FI manager, who wants
to analyze overall gap exposure, may ask: What
are the durations of such floating-rate securities?
The duration of a floating-rate instrument is generally the time interval between the purchase of
the security and the time when the next coupon
or interest payment is readjusted to reflect current
interest rate conditions. We call this the time to
repricing of the instrument.
For example, suppose the investor bought a
perpetual floating-rate note. These floating-rate
notes never mature. At the beginning of each year,
the FI sets the coupon rate, which is paid at the
end of that year. Suppose the investor buys the
bond in the middle of the first year (t ½) rather
than at the beginning (see Figure 9B–7).
The present value of the bond from time of
purchase is:
C1
C2
1
1
(1 2 R)
(1 2 R)(1 R)
C3
C4
2 1
1
(1 2 R)(1 R)
(1 2 R)(1 R)3
C5
...
1
(1 2 R)(1 R)4
C
1
(1 2 R)(1 R)1
P 272
Part Two
Measuring Risk
FIGURE 9B–7
Floating-Rate Note
Set C1
Pay C1
Set C2
0
1
Buy bond
1
at t = /2
Pay C2
Set C3
Pay C3
Set C4
Pay C4
Set C5
Pay C5
Set C6
2
3
4
5
Note three important aspects of this present
value equation. First, the investor has to wait only
a half year to get the first coupon payment—hence,
the discount rate is (1 ½R). Second, the investor
knows with certainty only the size of the first coupon C1, which was preset at the beginning of the
first coupon period to reflect interest rates at that
time. The FI set the first coupon rate six months
before the investor bought the bond. Third, the
other coupons on the bond, C2, C3, C4, C5, . . . C,
are unknown at the time the bond is purchased
because they depend on the level of interest rates
at the time they are reset (see Figure 9B–7).
To derive the duration of the bond, rewrite the
cash flows at one-half year onward as:
1
C1
P 1
(1 2 R)
(1 1 2 R)
C3
C4
⎡ C2
⎢ (1 R) (1 R)2 (1 R)3 ⎣
C5
C∞
⎤
... ∞ 1 ⎥
4 (1 R)
(1 R)
⎦
where P is the present value of the bond (the bond
price) at one-half year, the time of purchase.
The term in brackets is the present value or fair
price (P1) of the bond if it were sold at the end
of year 1, the beginning of the second coupon
period. As long as the variable coupons exactly
match fluctuations in yields or interest rates, the
present value of the cash flow in the square brackets is unaffected by interest rate changes. Thus,
P C1
P1
(1 1 2 R)
(1 1 2 R)
Since C1 is a fixed cash flow preset before the
investor bought the bond and P1 is a fixed cash flow
in present value terms, buying this bond is similar to buying two single-payment deep-discount
bonds each with a maturity of six months. Because
the duration of a deep-discount bond is the same
as its maturity, this floating rate bond has:
D 1
2
year
As indicated earlier, a half year is exactly the
interval between the time when the bond was
purchased and the time when it was first repriced.
DEMAND DEPOSITS
AND PASSBOOK SAVINGS
Many banks and thrifts hold large amounts of
checking and passbook savings account liabilities. This is especially true for smaller banks. The
problem in assessing the duration of such claims
is that their maturities are open-ended and many
demand deposit accounts do not turn over very
frequently. Although demand deposits allow
holders to demand cash immediately— suggesting a very short maturity—many customers tend
to retain demand deposit balances for lengthy
periods. In the parlance of banking, they behave
as if they were a bank’s core deposits. One way
for an FI manager to get around this problem
is to analyze the runoff, or the turnover characteristics, of the FI’s demand and passbook savings account deposits. For example, suppose
the manager learns that on average each dollar in demand deposit accounts turns over five
times a year. This suggests an average turnover
or maturity per dollar of around 73 days, (i.e.,
365 days/5).
A second method is to consider demand deposits as bonds that can be instantaneously put back
to the bank in return for cash. As instantaneously
putable bonds, the duration of demand deposits
is approximately zero.
Chapter 9
A third approach is more directly in line with
the idea of duration as a measure of interest rate
sensitivity. It looks at the percentage change of
demand deposits (ΔDD/DD) to interest rate
changes (ΔR). Because demand deposits and, to
a lesser extent, passbook savings deposits pay
either low explicit or implicit interest—where
implicit interest takes forms such as subsidized
checking fees—there tend to be enhanced withdrawals and switching into higher-yielding
instruments as rates rise. You can use a number
of quantitative techniques to test this sensitivity,
including linear and nonlinear time series regression analysis.
A fourth approach is to use simulation analysis. This is based on forecasts of future interest
rates and the net withdrawals by depositors from
their accounts over some future time period. Taking the discounted present values of these cash
flows allows a duration measure to be calculated.
MORTGAGES AND MORTGAGEBACKED SECURITIES
Calculating the durations of mortgages and
mortgage-backed securities is difficult because of
prepayment risk. Essentially, as the level of interest rates falls, mortgage holders have the option
Interest Rate Risk II
273
to prepay their old mortgages and refinance with
a new mortgage at a lower interest rate. In the
terminology of finance, fixed-rate mortgages and
mortgage-backed securities contain an embedded
option. Calculating duration requires projecting
the future cash flows on an asset. Consequently,
to calculate the duration of mortgages, we need
to model the prepayment behavior of mortgage
holders. Possible ways to do this are left to
Chapter 26 on mortgage asset securitization.
FUTURES, OPTIONS, SWAPS,
CAPS, AND OTHER CONTINGENT
CLAIMS
When interest rates change, so do the values of
(off-balance-sheet) derivative instruments such as
futures, options, swaps, and caps (see Chapter 16).
Market value gains and losses on these instruments
can also have an impact on the net worth (E) of an
FI. The calculation of the durations of these instruments is left to Chapters 22, 23, and 24. However,
it should be noted that a fully fledged duration
gap model of an FI should take into account the
durations of its derivatives portfolio as well as the
duration of its on-balance-sheet assets and liabilities. This is especially so today as more and more
FIs take positions in derivative contracts.
Chapter Ten
See Appendices Online at www.mhhe.com/saunders8e
• Appendix 10A: Credit Analysis
• Appendix 10B: Black–Scholes Option Pricing Model
Credit Risk:
Individual Loan Risk
INTRODUCTION
As discussed in Chapter 1, financial institutions (FIs) are special because of their
ability to efficiently transform financial claims of household savers into claims
issued to corporations, individuals, and governments. An FI’s ability to evaluate
information and to control and monitor borrowers allows it to transform these
claims at the lowest possible cost to all parties. One of the specific types of financial claim transformation discussed in Chapter 1 is credit allocation. That is, FIs
transform claims of household savers (in the form of deposits) into loans issued
to corporations, individuals, and governments. The FI accepts the credit risk on
these loans in exchange for a fair return sufficient to cover the cost of funding (e.g.,
covering the costs of borrowing, or issuing deposits) to household savers and the
credit risk involved in lending.
In this chapter, the first of two chapters on credit risk, we discuss various
approaches to analyzing and measuring the credit or default risk on individual
loans (and bonds). In the next chapter, we consider methods for evaluating the
risk of the overall loan portfolio, or loan concentration risk. Methods for hedging
and managing an FI’s credit risk, such as the use of credit derivative swaps, are
left to Chapters 22 through 26. Measurement of the credit risk on individual loans
or bonds is crucial if an FI manager is to (1) price a loan or value a bond correctly
and (2) set appropriate limits on the amount of credit extended to any one borrower or the loss exposure it accepts from any particular counterparty.
Indeed, the default of one major borrower can have a significant impact on
the value and reputation of many FIs. For example, total exposure of U.S. banks
to WorldCom at the time of its bankruptcy in 2002 was over $700 million. Losses
from this single failure resulted in a drop in earnings per share at J.P. Morgan
Chase of 5 cents (or nearly 2 percent), at then Bank One (Bank One is now a part
of J.P. Morgan Chase), of 3 cents (or 1 percent), and at Bank of America of 5 cents
(or 1 percent). Similarly, a single major economic event can cause losses to many
FIs’ loan portfolios. For example, in 2005 Hurricanes Katrina and Rita resulted
in over $1.3 billion in bad loans for major banks operating in areas hit by the
274
Chapter 10
Credit Risk: Individual Loan Risk
275
storm. And, of course, the financial market crisis of the late 2000s resulted in the
largest ever credit risk-related losses for U.S. financial institutions. Losses from
the falling value of on- and off-balance-sheet credit instruments (e.g., mortgages,
mortgage-backed securities, credit cards) topped $2.3 trillion worldwide, with
$1.6 trillion coming from loans and assets originated at U.S. financial institutions. In just the first quarter of 2009, the annualized net charge-off rate on total
loans and leases at U.S. banks was 1.94 percent, slightly below the 1.95 percent
rate in the fourth quarter of 2008 (that was the highest quarterly net chargeoff rate in the 25 years that insured institutions have reported these data). The
year-over-year rise in charge-offs was led by loans to commercial and industrial (C&I) borrowers, where charge-offs increased by $4.2 billion (170 percent),
then credit cards (up $3.4 billion, or 68.9 percent), real estate construction loans
(up $2.9 billion, or 161.7 percent), and 1–4 family residential real estate loans (up
$2.7 billion, or 64.9 percent).
Many financial institutions were unable to survive the mortgage crisis. For
example, Countrywide Financial, the country’s largest mortgage issuer, nearly
failed in the summer of 2007 due to defaults by its subprime mortgage borrowers. Only a $2 billion equity investment by Bank of America in 2007 and then an
acquisition by Bank of America in 2008 kept this thrift alive. IndyMac Bank, the
ninth largest mortgage lender in the U.S. in 2007, was seized by the FDIC in July
2008. At a cost to the FDIC of between $4 billion and $8 billion, IndyMac represented the largest bank failure in more than 20 years. Overall, in 2008–2010, 322
U.S. banks failed, compared to 3 in 2005–2007. Further, the Federal Deposit Insurance Corporation reported that it had 884 banks on its list of troubled institutions
at year end 2010, up from 90 in the first quarter of 2008. Most recently, bank loan
portfolios were exposed to losses from the European debt crisis. In early 2012,
U.S. banks had virtually no exposure to Greek debt, approximately $5.8 billion.
Despite this relatively insignificant amount, the risks posed to U.S. banks and the
banking system system from a Greek debt default and a contagion crisis in other
Eurozone countries were huge. U.S. banks had more than $50 billion worth of
debt exposure to both Spain and Ireland, $6.6 billion to Portugal, and more than
$66 billion to Italy, all countries in risk of debt default in the event of a continued
economic slowdown. Further, U.S. banks had even larger exposures to the larger
countries in Europe and to European banks. These seemingly unending creditrelated events stress that FIs need to manage their loan portfolios to protect the
overall FI from failure due to credit risk.
We begin this chapter with a look at the types of loans (commercial and industrial [C&I], real estate, individual (consumer), and others) as well as the characteristics of those loans made by U.S. FIs. We then look at how both interest and fees
are incorporated to calculate the return on a loan. This is followed by a discussion of how the return on a loan versus the quantity of credit made available for
lending is used by FIs to make decisions on wholesale (C&I) versus retail (consumer) lending. Finally, we examine various models used to measure credit risk,
including qualitative and quantitative models (credit scoring models and newer
models of credit risk measurement). Indeed, technological advances have been at
least one driving force behind the advances and new models of credit risk measurement and management in recent years. Appendix 10A, located at the book’s
website (www.mhhe.com/saunders8e), discusses cash flow and financial ratio
analysis widely used in the credit analysis process for mortgage, consumer, and
commercial loans.
276
Part Two
Measuring Risk
CREDIT QUALITY PROBLEMS
junk bonds
Bonds rated as speculative or less than
investment grade by
bond-rating agencies
such as Moody’s.
www.moodys.com
www.standardandpoors.com
FIGURE 10–1
Over the past three decades the credit quality of many FIs’ lending and investment decisions has attracted a great deal of attention. In the 1980s there were tremendous problems with bank loans to less developed countries (LDCs) as well
as with thrift and bank residential and farm mortgage loans. In the early 1990s
attention switched to the problems of commercial real estate loans (to which
banks, thrifts, and insurance companies were all exposed) as well as junk bonds
(rated as speculative or less than investment grade securities by bond-rating
agencies such as Moody’s or Standard & Poors). In the late 1990s concerns shifted
to the rapid growth in low-quality auto loans and credit cards as well as the
declining quality in commercial lending standards as loan delinquencies started
to increase. In the late 1990s and early 2000s, attention focused on problems
with telecommunication companies, new technology companies, and a variety
of sovereign countries including at various times Argentina, Brazil, Russia, and
South Korea. Despite these credit concerns, the credit quality of most FIs improved
throughout the 1990s. For example, for FDIC-insured commercial banks, the ratio
of nonperforming loans to assets declined significantly from 1992 through 2000
(see Figure 10–1).1
The recession in the U.S. economy in the early 2000s led to a reversal in this
trend as nonperforming loan rates increased, particularly on commercial and
industrial (C&I) loans. However, the nonperformance of loans in all categories
was still below that of the early 1990s. As the U.S. economy improved in the mid2000s, nonperforming loan rates fell. However, mortgage delinquencies, particularly on subprime mortgages, surged in the last quarter of 2006 and all of 2007 as
home owners who stretched themselves financially to buy a home or refinance
Nonperforming Asset Ratio for U.S. Commercial Banks
Source: Federal Deposit Insurance Corporation, Quarterly Banking Profile, various issues. www.fdic.gov
Percentage
of loans
10
Total real estate
Commercial and industrial
Loans to individuals
All other loans
9
8
7
6
5
4
3
2
1
Year
0
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
1
Nonperforming loans are loans that are 90 days or more past due or are not accruing interest.
Chapter 10
Credit Risk: Individual Loan Risk
277
a mortgage in the early 2000s fell behind on their loan payments. Trouble in
the mortgage markets continued to escalate as the number of foreclosures hit a
record 1.5 million in the first six months of 2009. Nonperforming real estate loans
reached levels higher than those seen in the 1980s. Problems in the mortgage markets spread to other sectors as well. In 2008 consumer bankruptcy filings rose to
1.06 million, up from 801,840 in 2007 and 602,000 in 2006. Business loan losses
grew as well. For example, when Chrysler went into bankruptcy in May 2009, it
owed banks, including Citigroup and J.P. Morgan Chase, $6.9 billion. President
Obama’s plan for Chrysler’s bankruptcy cut that to $1 billion for a loss to banks
of $5.9 billion. The banks ended up realizing 33 cents on the dollar for these loans,
a loss of $4.6 billion. As the U.S. economy slowly recovered in 2010–2012, nonperforming loans rates edged downward but still remained at levels higher than
those seen throughout most of the 30-year period.
Internet Exercise
Go to the Federal Deposit Insurance Corporation website and find the latest information
available for nonperforming loans at commercial banks in the United States, using the following steps: Go to the Federal Deposit Insurance Corporation website at www.fdic.gov.
Click on “Analysts.” Click on “FDIC Quarterly Banking Profile.” Click on “Quarterly Banking
Profile.” Click on the most recent date and “Commercial Bank Section.” Click on “TABLE
V-A. Loan Performance.” This will download a file on to your computer that will contain the
most recent information as “Percent of Loans Noncurrent: Total Loans and Leases.”
Credit quality problems, in the worst case, can cause an FI to become insolvent or can result in such a significant drain on capital2 and net worth that they
adversely affect its growth prospects and ability to compete with other domestic
and international FIs. However, credit risk does not apply only to traditional areas
of lending and bond investing. As banks and other FIs have expanded into credit
guarantees and other off-balance-sheet activities (see Chapter 16), new types of
credit risk exposure have arisen, causing concern among managers and regulators. Thus, credit risk analysis is now important for a whole variety of contractual
agreements between FIs and counterparties.3
Concept
Questions
1. What are some of the credit quality problems faced by FIs over the last three decades?
2. What are some of the newer, nontraditional activities that create credit risk for today’s FIs?
2
Losses drain capital through the income statement item “provision for loan losses.” The provision for
loan losses is a noncash, tax-deductible expense representing the FI management’s prediction of loans at
risk of default for the current period. As credit quality problems arise, the FI recognizes its expected bad
loans by recording this expense, which reduces net income and, in turn, the FI’s capital. The provision for
loan losses is then allocated to the allowance for loan losses listed on the balance sheet. The allowance
for loan and lease losses is a cumulative estimate by the FI’s management of the gross loans (and leases)
that will not be repaid to the FI. Actual losses are then deducted from, and recoveries are added to
(referred to as net write-offs), their accumulated loans and lease loss reserve balance. See Appendix 2A,
“Commercial Banks’ Financial Statements and Analysis” (located at the book’s website, www.mhhe.com/
saunders8e) for a more detailed discussion of these items.
3
This is one of the reasons for bank regulators’ setting capital requirements against credit risk (see
Chapter 20).
278
Part Two
Measuring Risk
TYPES OF LOANS
Although most FIs make loans, the types of loans made and the characteristics
of those loans differ considerably. This section analyzes the major types of loans
made by U.S. financial institutions. Table 10–1 shows a recent breakdown of the
aggregate loan portfolio of U.S. commercial banks into four broad classes: commercial and industrial (19.6 percent of all commercial bank loans), real estate
(52.9 percent), individual (17.5 percent), and all others (10.0 percent). We look
briefly at each of these loan classes in turn.
Commercial and Industrial Loans
syndicated loan
A loan provided by
a group of FIs as
opposed to a single
lender.
secured loan
A loan that is backed
by a first claim on certain assets (collateral)
of the borrower if
default occurs.
unsecured loan
A loan that has only
a general claim to the
assets of the borrower
if default occurs.
The figures in Table 10–1 disguise a great deal of heterogeneity in the commercial
and industrial loan portfolio. Indeed, commercial loans can be made for periods
as short as a few weeks to as long as eight years or more. Traditionally, short-term
commercial loans (those with an original maturity of one year or less) are used to
finance firms’ working capital needs and other short-term funding needs, while
long-term commercial loans are used to finance credit needs that extend beyond
one year, such as the purchase of real assets (machinery), new venture start-up
costs, and permanent increases in working capital. They can be made in quite
small amounts, such as $100,000, to small businesses or in packages as large as
$10 million or more to major corporations. Large C&I loans are often syndicated.
A syndicated loan is provided by a group of FIs as opposed to a single lender.
A syndicated loan is structured by the lead FI (or agent) and the borrower. Once
the terms (rates, fees, and covenants) are set, pieces of the loan are sold to other
FIs. In addition, C&I loans can be secured or unsecured. A secured loan (or assetbacked loan) is backed by specific assets of the borrower. If the borrower defaults,
the lender has a first lien or claim on those assets. Secured debt is senior to an
unsecured loan (or junior debt) that has only a general claim on the assets of the
borrower if default occurs. As we explain later in this chapter, there is normally a
trade-off between the security or collateral backing of a loan and the loan interest
rate or risk premium charged by the lender on a loan.
In addition, commercial loans can be made at either fixed or floating rates of
interest. A fixed-rate loan has the rate of interest set at the beginning of the contract period. This rate remains in force over the loan contract period no matter
what happens to market rates. Suppose, for example, IBM borrowed $10 million at
a fixed rate of 10 percent for one year, but the FI’s cost of funds rose over the course
of the year. Because this is a fixed-rate loan the FI bears all the interest rate risk.
This is why many loans have floating-rate contractual terms; that is, IBM borrows
$10 million at a floating rate, e.g., LIBOR 5 percent, for one year. The loan rate
can be periodically adjusted according to a formula so that the interest rate risk is
TABLE 10–1
Types of U.S. Bank
Loans (in billions of
dollars)
Source: Federal Reserve
Board, Assets and Liabilities of
Commercial Banks, June 2012.
www.federalreserve.gov
Total loans*
C&I
Real estate
Individual
Other
Amount
Percent
$6,739.8
1,322.1
3,562.3
1,183.0
672.4
100.0%
19.6
52.9
17.5
10.0
*Excluding interbank loans.
Chapter 10
spot loan
The loan amount
is withdrawn
by the borrower
immediately.
loan commitment
A credit facility with
a maximum size and
a maximum period of
time over which the
borrower can withdraw funds; a line of
credit.
commercial paper
Unsecured shortterm debt instrument issued by
corporations.
Credit Risk: Individual Loan Risk
279
transferred in large part from the FI to the borrower. As might be expected, longerterm loans are more likely to be made under floating-rate contracts than are relatively short-term loans.4
Finally, loans can be made either spot or under commitment. A spot loan is
made by the FI, and the borrower uses or takes down the entire loan amount immediately. With a loan commitment, or line of credit, the lender makes an amount of
credit available, such as $10 million. The borrower has the option to take down any
amount up to the $10 million at any time over the commitment period. In a fixedrate loan commitment, the interest rate to be paid on any takedown is established
when the loan commitment contract originates. In a floating-rate commitment, the
borrower pays the loan rate in force when the loan is actually taken down. For
example, suppose the $10 million floating-rate IBM loan was made under a oneyear loan commitment. When the loan commitment was originated (say, January
2015), IBM borrows nothing. Instead, it waits until six months have passed (say,
July 2015) before it takes down the entire $10 million. Since this is a floating-rate
loan commitment, IBM pays the loan rate in force as of July 2015. We discuss the
special features of loan commitments more fully in Chapter 16.
To determine the basic characteristics of C&I loans, the Federal Reserve surveys
more than 400 banks each quarter. Table 10–2 shows the major characteristics in a
recent lending survey. As you can see, more short-term (under one year) C&I loans
($62.27 billion) than long-term loans ($3.36 billion) were reported. Also, short-term
loans are less likely to be backed or secured by collateral (ranging from 27.1 percent
for daily loans to 67.9 percent for zero loans) than long-term loans (80.7 percent).
Finally, as we noted in Chapter 2, commercial loans are declining in importance
in bank loan portfolios. The major reason for this has been the rise in nonbank
loan substitutes, especially commercial paper. Commercial paper is an unsecured
short-term debt instrument issued by corporations either directly or via an underwriter to purchasers in the financial markets, such as money market mutual funds.
TABLE 10–2 Characteristics of Commercial Loan Portfolios, March 2012
Source: Federal Reserve Board website, June 2012. www.federalreserve.gov
Long-Term
Loans
Amount outstanding ($ billions)
Average size of loan ($ thousands)
Percent of which made under
commitment
Percent of loans secured by collateral
Short-Term Loans
Zero*
Daily
2 to 30 days
31 to 365 days
$3.36
$355
88.8%
$17.96
$294
95.9%
$17.34
$2,282
31.9%
$20.87
$501
83.5%
$6.10
$713
89.7%
80.7%
67.9%
27.1%
39.9%
54.6%
*Floating-rate loans that are subject to repricing at any time.
4
However, floating-rate loans are more credit risky than fixed-rate loans, holding all other contractual
features the same. This is because floating-rate loans pass the risk of all interest rate changes onto borrowers. Thus, in rising interest rate environments, floating-rate borrowers may find themselves unable
to pay the interest on their loans and may be forced to default. This is what happened in the mortgage
markets in the late 2000s and ignited the financial crisis. The benefit of floating-rate loans to lenders is
that they better enable FIs to hedge the cost of rising interest rates on liabilities (such as deposits). This
suggests that controlling interest rate risk may be at the expense of enhanced credit risk.
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Part Two
Measuring Risk
By using commercial paper, a corporation can sidestep banks and the loan market
to raise funds often at rates below those banks charge. As of June 2012, the total
commercial paper outstanding in the United States was $1,007.1 billion compared
with C&I loans of $1,322.1 billion. Prior to the financial crisis, in December 2007
commercial paper outstanding was $1,788.1 billion compared to $1,445.8 billion in
bank loans. Moreover, since only the largest corporations can tap the commercial
paper market, banks are often left with a pool of increasingly smaller and riskier
borrowers in the C&I loan market. For example, as the U.S. economy slowed in the
early 2000s, noncurrent (loans that are 90 days or more past due or are not accruing interest) C&I loans increased from $14 billion (in the fourth quarter of 1999)
to almost $24 billion (in the second quarter of 2003). As the economy strengthened in the mid-2000s, this amount decreased to $2.4 billion. The recession and
financial crisis in the late 2000s saw noncurrent C&I loans grow again; to a high of
$45 billion in the third quarter of 2009.
The commercial paper market was also hard hit by the financial crisis, but not
because of nonperformance issues related to the commercial paper issuing firms.
At the height of the crisis, in September 2008, money market mutual fund withdrawals skyrocketed. Fund investors pulled out a record $144.5 billion during the
week ending Wednesday, September 17 (redemptions during the week of September 10 totaled just $7.1 billion), as investors worried about the safety of even these
safest investments. Money market mutual funds participated heavily in the $1.7
trillion commercial paper market, which provided a bulk of the short-term funds
to corporations. As investors pulled their money from these funds, the commercial
paper market shrank by $52.1 billion for the week (through Wednesday). These
outflows severely undermined the stability of short-term funding markets, upon
which many large corporations rely heavily to meet their short-term borrowing
needs. In response, businesses that had them drew down their loan commitments
at FIs. Thus, C&I loans issued by commercial banks increased as the commercial
paper market decreased in size.
Real Estate Loans
Real estate loans are primarily mortgage loans and some revolving home equity
loans (approximately 13 percent of the real estate loan portfolio in March 2012).5
We show the distribution of mortgage debt for U.S. banks in 2012 in Table 10–3.
For banks (as well as thrifts), residential mortgages are still the largest component
of the real estate loan portfolio (63.5 percent in 2012).
TABLE 10–3
Percent
Distribution of
U.S. Commercial
Bank Real Estate
Mortgage Debt
One- to four-family residences
Multifamily residences
Commercial
Farm
Source: Federal Deposit
Insurance Corporation
website, June 2012.
www.fdic.gov
63.5%
5.1
29.3
2.1
100.0%
5
Under home equity loans, borrowers use the equity they have in their homes as collateral backing for loans.
Chapter 10
FIGURE 10–2
Credit Risk: Individual Loan Risk
281
ARMs’ Share of Total Loans Closed, 1987–2012
Sources: Federal Housing Finance Agency website, www.fhfa.gov, and Federal Reserve Board website, www.federalreserve.gov.
70
ARMs’ share (%)
12
ARMs’ share(%)
30-year mortgage rate (%)
11
60
10
50
9
40
8
30
7
20
6
10
5
0
1987
1989
adjustable-rate
mortgage (ARM)
A mortgage whose
interest rate adjusts
with movements in
an underlying market
index interest rate.
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
30-year mortgage rates (%)
80
4
2011 Year
As with C&I loans, the characteristics of residential mortgage loans differ
widely. These characteristics include the size of the loan, the ratio of the loan to
the property’s price (the loan price or loan value ratio), and the maturity of the
mortgage. Other important characteristics are the mortgage interest (or commitment) rate and fees and charges on the loan, such as commissions, discounts, and
points paid by the borrower or the seller to obtain the loan.6 In addition, the mortgage rate differs according to whether the mortgage has a fixed rate or a floating
rate, also called an adjustable rate. Adjustable-rate mortgages (ARMs) have their
contractual rates periodically adjusted to some underlying index, such as the oneyear T-bill rate. The proportion of fixed-rate mortgages to ARMs in FI portfolios
varies with the interest rate cycle. In low–interest rate periods, borrowers prefer
fixed-rate to adjustable-rate mortgages. As a result, the proportion of ARMs to
fixed-rate mortgages can vary considerably over the rate cycle. In Figure 10–2,
note the behavior of ARMs over one recent interest rate cycle—1999 to 2007—
when interest rates (and ARMs) rose, then fell, and then rose and fell again. Note
also that ARMs were virtually nonexistent in late 2008 and 2009 as the federal
government, in an effort to stimulate the devasted housing market, took actions
that lowered fixed mortgage rates to historic lows. Table 10–4 presents a summary
of the major contractual terms on conventional fixed-rate mortgages as of 2012.
TABLE 10–4
Purchase price ($ thousands)
Amount of loan ($ thousands)
Loan-to-value ratio (percent)
Maturity (years)
Fees and charges (percent of loan amount)
Contract rate (percent)
Contractual Terms
on Conventional
New Home
Mortgages
Source: Federal Housing
Finance Agency, Mortgage
Interest Rates, June 2012.
www.fhfa.gov
6
$349.2
$256.2
75.3%
27.3
0.90%
3.93%
Points are a certain percentage of the face value of the loan paid up front, as a fee, by the borrower to
the lender.
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Part Two
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Home buyers raised an average of 75.3 percent of the value of their new homes by
borrowing through mortgage loans. Rates charged on the average loan remained
at historical lows (3.93 percent), and mortgage lenders charged an additional
0.9 percent in fees for processing the mortgages.
Residential mortgages are very long-term loans with an average maturity of
29 years. To the extent that house prices can fall below the amount of the loan
outstanding—that is, the loan-to-value ratio rises—the residential mortgage portfolio can also be susceptible to default risk. For example, during the collapse in
real estate prices in the late 2000s, many house prices actually fell below the prices
of the mid-2000s. This led to a dramatic surge in the level of mortgage defaults
and eventually foreclosures by banks and thrifts.
Individual (Consumer) Loans
revolving loan
A credit line on which
a borrower can both
draw and repay many
times over the life of
the loan contract.
Another major type of loan is the individual, or consumer, loan, such as personal
and auto loans. Commercial banks, finance companies, retailers, savings institutions, credit unions, and oil companies also provide consumer loan financing
through credit cards, such as Visa, MasterCard, and proprietary credit cards issued
by, for example, Sears and AT&T. Credit card transactions typically must be authorized by the cardholder’s bank. Thus, verification of satisfactory credit quality
occurs with each transaction. The five largest credit card issuers and their outstanding balances in 2011 are shown in Table 10–5. Together, these five credit card
issuers hold more than 66 percent of all outstanding balances.
In Table 10–6 are the two major classes of consumer loans at U.S. banks. The
largest class of loans is nonrevolving consumer loans (66.2 percent), which include
new and used automobile loans, mobile home loans, and fixed-term consumer
loans such as 24-month personal loans. The other major class of consumer loans is
revolving loans (33.8 percent), such as credit card debt. With a revolving loan, the
borrower has a credit line on which to draw as well as to repay, up to some maximum over the life of the credit contract. In recent years, bank’s have faced chargeoff rates between 4 and 8 percent on their credit card loans outstanding. Note
particularly that in October 2005, the Bankruptcy Reform Act was signed into law.
TABLE 10–5
Biggest Credit Card
Issuers
Source: The Nilson Report,
February 2012.
Card Issuer
J.P. Morgan Chase
Bank of America
Citigroup
American Express
Capital One Financial
TABLE 10–6
Types of Consumer
Loans at Commercial
Banks
Source: Federal Reserve
Board website, Consumer
Credit, June 2012.
www.federalreserve.gov
Total Outstanding
Balances ($ billions)
Market Share,
2011
Market Share,
2010
$130.02
112.62
92.33
80.25
50.88
18.23%
15.79
12.94
11.92
7.13
18.64%
17.19
13.34
11.28
7.05
Percent
Revolving
Nonrevolving
33.8%
66.2
100.0%
Chapter 10
FIGURE 10–3
Credit Risk: Individual Loan Risk
283
Annual Net Charge-Off Rates on Loans
Source: Federal Deposit Insurance Corporation, Quarterly Banking Profile, various issues. www.fdic.gov
Number of bankruptcies
(thousands)
Percent of
loans
14
1100
13
1000
12
900
11
Personal bankruptcy filings
Credit card charge-offs
C&I charge-offs
10
9
800
700
8
7
600
6
500
5
400
4
3
300
2
200
1
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2012 2012
usury ceilings
National-, state-, or
city-imposed ceilings
on the maximum
rate FIs can charge
on consumer and
mortgage debt.
This act made it more difficult for consumers to declare bankruptcy. As a result,
there was a surge in bankruptcy filings in the summer and early fall of 2005, just
before the new rules went into effect. Consequently, banks saw a surge in credit
card charge-offs. These charge-off rates were significantly higher than those on
commercial loans (see Figure 10–3). Note also that the level of credit card charge
offs rose sharply during the financial crisis (to over 13 percent), which is significantly higher than that seen on commercial loan charge offs (which peaked at
8.7 percent). Such relatively high default rates again point to the importance of
risk evaluation prior to the credit decision.
In Table 10–7 we show indicative interest rates on car (5.07 percent), personal
(10.88 percent), and credit card (12.34 percent) loans as of February 2012. These
rates differ widely depending on features such as collateral backing, maturity,
default rate experience, and non–interest rate fees. In addition, competitive conditions in each market as well as regulations such as national-, state-, or city-imposed
usury ceilings (maximum rates FIs can charge on consumer and mortgage debt)
all affect the rate structure for consumer loans. For example, in 2012 federally
chartered credit unions were prohibited from charging more than 18 percent on
any loan.
TABLE 10–7
Interest Rate Terms
on Consumer Loans
Source: Federal Reserve
Board website, Consumer
Credit, June 2012.
www.federalreserve.gov
Percent
48-month car loan
24-month personal loan
Credit card
5.07%
10.88
12.34
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Measuring Risk
Other Loans
The “other loans” category can include a wide variety of borrowers and types,
including farmers, other banks, nonbank financial institutions such as broker
margin loans (loans financing a percentage of an individual investment portfolio), state and local governments, foreign banks, and sovereign governments. We
discuss sovereign loans in Chapter 14.
Concept
Questions
1. What are the four major types of loans made by U.S. commercial banks? What are
the basic distinguishing characteristics of each type of loan?
2. Will more ARMs be originated in high- or low-interest-rate environments? Explain
your answer.
3. In Table 10–7, explain why credit card loan rates are much higher than car loan rates.
CALCULATING THE RETURN ON A LOAN
An important element in the credit management process, once the decision to
make a loan has been made, is its pricing. This includes adjustments for the perceived credit risk or default risk of the borrower as well as any fees and collateral
backing the loan.7 This section demonstrates one method used to calculate the
return on a loan: the traditional return on assets approach. Although we demonstrate the return calculations using examples of commercial and industrial loans,
the techniques can be used to calculate the return on other loans (such as credit
card or mortgage loans) as well.
The Contractually Promised Return on a Loan
The previous description of loans makes it clear that a number of factors impact
the promised return an FI achieves on any given dollar loan (asset) amount. These
factors include the following:
1.
2.
3.
4.
5.
The interest rate on the loan.
Any fees relating to the loan.
The credit risk premium on the loan.
The collateral backing of the loan.
Other nonprice terms (especially compensating balances and reserve
requirements).
First, let us consider an example of how to calculate the promised return on a
C&I loan. Suppose that an FI makes a spot one-year, $1 million loan. The loan rate
is set as follows:
Base lending rate (BR) 12%
Credit risk premium or margin ( ) 2%
BR 14%
7
FIs have developed relationship pricing programs, which offer discounts on interest rates for customers
based on the total amount of fee-based services used and investments held at the FI. Relationship pricing
is in contrast to (the more traditional) transaction pricing, in which customers pay a stated rate for a service regardless of the total amount of other (nonloan) business conducted with the FI.
Chapter 10
LIBOR
The London Interbank Offered Rate,
which is the rate for
interbank dollar loans
of a given maturity in
the offshore or Eurodollar market.
prime lending rate
The base lending rate
periodically set by
banks.
compensating
balance
A percentage of a
loan that a borrower
is required to hold on
deposit at the lending
institution.
Credit Risk: Individual Loan Risk
285
The base lending rate (BR) could reflect the FI’s weighted-average cost of capital or its marginal cost of funds, such as the commercial paper rate, the federal
funds rate, or LIBOR—the London Interbank Offered Rate, which is the rate for
interbank dollar loans of a given maturity in the Eurodollar market. The center of
the Eurodollar market is London. Initially, most variable-rate business loans were
tied to the U.S. fed funds rate. However, the tremendous growth of the Eurodollar
market has resulted in the LIBOR becoming the standard rate by which these loan
rates are now priced. For example, the commercial paper market in the United
States now quotes rates as a spread over the LIBOR rate rather than over the Treatsury bill rate. Higher LIBOR rates result in higher borrowing costs for businesses
while lower rates can make FIs hesitant to lend. In addition to business loans,
some bonds and interest rate swaps also use LIBOR as their benchmark. The After
the Crisis box looks at allegations that several large banks tried to manipulate the
LIBOR rate during the financial crisis. Because of the extensive use of LIBOR as a
base rate on business loans, and even mortgages and credit card rates, even a small
bit of manipulation can cause massive redistribution of resources. In addition to
the Canadian government, the U.S. Justice Department as well as officials in Switzerland and the United Kingdom are involved in the investigation. As stated in
the box, in June 2012, the British bank Barclays agreed to pay $453 million to U.S.
and British authorities to settle allegations that it manipulated the LIBOR. The
Barclays settlement put increasing pressure on other banks to cooperate in the
probe that could cost the financial industry billions of dollars and brought to question the use of LIBOR as the benchmark loan rate.
Alternatively, the base lending rate could reflect the prime lending rate. The
prime rate is most commonly used in pricing longer-term loans, while the fed funds
rate and LIBOR rate are most commonly used in pricing short-term loans. Traditionally, the prime rate has been the rate charged to the FI’s lowest-risk customers.
Now, it is more of a base rate to which positive or negative risk premiums (f)
can be added. In other words, the best and largest borrowers now commonly pay
below prime rate to be competitive with the commercial paper market.
Direct and indirect fees and charges relating to a loan generally fall into three
categories:
1. A loan origination fee (of ) charged to the borrower for processing the application.
2. A compensating balance requirement (b) to be held as (generally non-interestbearing demand) deposits. Compensating balances are a percentage of a loan
that a borrower cannot actively use for expenditures. Instead, these balances
must be kept on deposit at the FI. For example, a borrower facing a 10 percent
compensating balance requirement on a $100 loan would have to place $10 on
deposit (traditionally on demand deposit) with the FI and could use only $90
of the $100 borrowed. This requirement raises the effective cost of loans for the
borrower since less than the full loan amount ($90 in this case) can actually be
used by the borrower and the deposit rate earned on compensating balances is
less than the borrowing rate. Thus, compensating balance requirements act as
an additional source of return on lending for an FI.8
3. A reserve requirement (RR) imposed by the Federal Reserve on the FI’s (specifically
depository institution’s) demand deposits, including any compensating balances.
8
They also create a more stable supply of deposits and thus mitigate liquidity problems. Further, compensating balances are sometimes used as an offset to fees charged on the loan. That is, loans with a compensating balance requirement often have lower fees than loans without a compensating balance. In this
case, the additional revenue from the compensating balances is offset by the loss in fee income.
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Part Two
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After the Crisis
Interest Rate Probe Escalates: Barclays Agrees to Pay
Record Fine; Emails Show Traders Tried to Manipulate Libor
Barclays agreed to pay $453 million in fines after admitting that traders and executives tried to manipulate
benchmark interest rates tied to loans and contracts
around the world . . . A series of Wall Street Journal
articles in 2008 raised questions about whether global
banks were manipulating the process by low-balling a
key interest rate to avoid looking desperate for cash
amid the financial crisis. Emails and instant messages
disclosed in the bank’s settlement show how Barclays’s
traders tried to manipulate rates to benefit their own
trading positions. “This is the way you pull off deals
like this chicken,” one trader told another trader in
March 2007, according to the U.K. regulator. “Don’t
tell ANYBODY.”. . .
The unusually steep punishment reflected what
officials said were serious and widespread efforts by
traders and senior managers at Barclays to manipulate the London Interbank Offered Rate, or Libor,
and the Euro Interbank Offered Rate, or Euribor. The
rates are used globally to help set the price of many
types of loans, from home mortgages to commercial
borrowing. The bank’s $200 million fine with the
Commodity Futures Trading Commission was the
U.S. agency’s largest penalty ever . . . Other banks
that have disclosed they are under investigation
include Citigroup Inc., HSBC Holdings, J.P. Morgan
Chase, Lloyds Banking Group, and Royal Bank of
Scotland Group PLC. None of these banks have been
charged with any wrongdoing in the matter by U.S.
or U.K. regulators.
The CFTC filing said the wrongful conduct at Barclays lasted at least four years and “at times occurred
on an almost daily basis.” In an October 2006 email
quoted by the U.K. regulator, an employee at another
bank told a Barclays trader to try to get the benchmark rate lower, saying: “If it comes in unchanged
I’m a dead man.” Hours later he offered a bottle of
Bollinger as thanks for the attempted manipulation:
“Dude. I owe you big time!”. . .
Libor is set each day in London based on estimates
submitted by a panel of banks. The banks are supposed to say how much it would cost them to borrow
from each other in different currencies over different
time periods. The CFTC said the rates affect “enormous volumes” of financial transactions, including
$360 trillion of swaps and loans, as well as futures
traded on the Chicago Mercantile Exchange with a
notional value in 2011 of more than $564 trillion . . .
In its filing, the CFTC alleged that a senior manager at
Barclays warned the bankers’ association in a phone
call in 2008 that the bank hadn’t been submitting
accurate Libor rates.
Source: The Wall Street Journal, June 28, 2012, by Jean
Eaglesham and Max Colchester. Reprinted by permission
of The Wall Street Journal. © 2012 Dow Jones & Company,
Inc. All rights Reserved Worldwide. www.wsj.com
While credit risk may be the most important factor ultimately affecting the return
on a loan, these other factors should not be ignored by FI managers in evaluating
loan profitability and risk. Indeed, FIs can compensate for high credit risk in a number of ways other than charging a higher explicit interest rate or risk premium on
a loan or restricting the amount of credit available. In particular, higher fees, high
compensating balances, and increased collateral backing all offer implicit and indirect methods of compensating an FI for lending risk. The contractually promised
gross return on the loan, k, per dollar lent—or ROA per dollar lent—equals:9
1k 1
of (BR )
1 [b(1 RR)]
This formula may need some explanation. The numerator is the promised gross
cash inflow to the FI per dollar lent, reflecting direct fees (of ) plus the loan interest
9
This formula ignores present value aspects that could easily be incorporated. For example, fees are
earned in up-front undiscounted dollars while interest payments and risk premiums are normally paid on
loan maturity and thus should be discounted by the FI’s cost of funds.
Chapter 10
Credit Risk: Individual Loan Risk
287
rate (BR f). In the denominator, for every $1 the FI lends, it retains b as noninterest-bearing compensating balances. Thus, 1 b is the net proceeds of each
$1 of loans received by the borrower from the FI, ignoring reserve requirements.
However, since b (the compensating balance) is held by the borrower at the FI in
a demand deposit account, the Federal Reserve requires depository institutions to
hold non- (or low) interest-bearing reserves at the rate RR against the compensating balance. Thus, the FI’s net benefit from requiring compensating balances must
consider the cost of holding additional reserve requirements. The net outflow by
the FI per $1 of loans is 1 [b(1 RR)], or 1 minus the reserve adjusted compensating balance requirement.
EXAMPLE 10–1
Calculation of
ROA on a Loan
Suppose a bank does the following:
1. Sets the loan rate on a prospective loan at 10 percent (where BR 6% and f 4%).
2. Charges a 1/8 percent (or 0.125 percent) loan origination fee to the borrower.
3. Imposes a 8 percent compensating balance requirement to be held as non-interest-bearing
demand deposits.
4. Sets aside reserves, at a rate of 10 percent of deposits, held at the Federal Reserve (i.e., the
Fed’s cash-to-deposit reserve ratio is 10 percent).
Plugging the numbers from our example into the return formula, we have:10
0.00125 (0.06 0.04)
1 [(0.08)(0.9)]
0.10125
1 k 1
0.928
1 k 1.1091 or k 10.91%
1 k 1
This is, of course, greater than the simple promised interest return on the loan,
BR f 10%.
In the special case where fees (of ) are zero and the compensating balance (b) is
zero:
of 0
b 0
the contractually promised return formula reduces to:
1 k 1 (BR )
That is, the credit risk premium or margin (f) is the fundamental factor driving
the promised return on a loan once the base rate on the loan is set.
Note that as commercial lending markets have become more competitive, both
origination fees (of ) and compensating balances (b) are becoming less important.
For example, where compensating balances are still charged, the FI may now
allow them to be held as time deposits, and they earn interest. As a result, borrowers’ opportunity losses from compensating balances have been reduced to
10
If we take into account the present value effects on the fees and the interest payments and assume
that the bank’s discount rate (d ) was 10.5 percent, then the BR f term needs to be discounted by
1 d 1.105, while fees (as up-front payments) are undiscounted. In this case, k is 9.89 percent.
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Measuring Risk
the difference between the loan rate and the compensating balance time-deposit
rate.11 Further, compensating balance requirements are very rare on international
loans such as Eurodollar loans. Finally, note that for a given promised gross return
on a loan, k, FI managers can use the pricing formula to find various combinations
of fees, compensating balances, and risk premiums they may offer their customers
that generate the same returns.
The Expected Return on a Loan
default risk
The risk that the borrower is unable or
unwilling to fulfill the
terms promised under
the loan contract.
The promised return on the loan (1 k) that the borrower and lender contractually agree on includes both the loan interest rate and non–interest rate features
such as fees. The promised return on the loan, however, may well differ from the
expected and, indeed, actual return on a loan because of default risk. Default risk
is the risk that the borrower is unable or unwilling to fulfill the terms promised
under the loan contract. Default risk is usually present to some degree in all loans.
Thus, at the time the loan is made, the expected return [E(r)] per dollar lent is
related to the promised return as follows:
1 E(r ) p(1 k ) (1 p)0
where p is the probability of complete repayment of the loan (such that the FI
receives the principal and interest as promised) and (1 p) is the probability of
default (in which the FI receives nothing, i.e., 0). Rearranging this equation, we get:
E(r ) p (1 k ) 1
To the extent that p is less than 1, default risk is present. This means the FI manager must (1) set the risk premium (f) sufficiently high to compensate for this
risk and (2) recognize that setting high risk premiums as well as high fees and
base rates may actually reduce the probability of repayment (p). That is, k and p
are not independent. Indeed, over some range, as fees and loan rates increase, the
probability that the borrower pays the promised return may decrease (i.e., k and p
may be negatively related). As a result, FIs usually have to control for credit risk
along two dimensions: the price or promised return dimension (1 k) and the
quantity or credit availability dimension. Further, even after adjusting the loan rate
for the default risk of the borrower (by increasing the risk premium on the loan),
there is no guarantee that the FI will actually receive the promised payments. The
measurement and pricing approaches discussed in the chapter consider credit risk
based on probabilities of receiving promised payments on the loan. The actual payment or default on a loan once it is issued may vary from the probability expected.
In general, compared with wholesale (e.g., C&I) loans, the quantity dimension
controls credit risk differences on retail (e.g., consumer) loans more than the price
dimension does. We discuss the reasons for this in the next section. That is followed by a section that evaluates various ways FI managers can assess the appropriate size of f, the risk premium on a loan. This is the key to pricing wholesale
loan and debt risk exposures correctly.
11
If compensating balances held as deposits paid interest at 2 percent (rd 2%), then the numerator
(cash flow) of the bank in the example would be reduced by b rd, where rd 0.02 and b 0.08. In
this case, the k 10.74 percent. This assumes that the reserve requirement on compensating balances
held as time deposits (RR) is 10 percent. However, while currently reserve requirements on demand
deposits are 10 percent, the reserve requirement on time deposits is 0 percent (zero). Recalculating but
assuming RR 0 and interest of 2 percent on compensating balances, we find k 10.83 percent.
Chapter 10
Concept
Questions
Credit Risk: Individual Loan Risk
289
1. Calculate the promised return (k) on a loan if the base rate is 13 percent, the risk
premium is 2 percent, the compensating balance requirement is 5 percent, fees are
½ percent, and reserve requirements are 10 percent. (16.23%)
2. What is the expected return on this loan if the probability of default is 5 percent? (10.42%)
RETAIL VERSUS WHOLESALE CREDIT DECISIONS
Retail
credit rationing
Restricting the quantity of loans made
available to individual borrowers.
Because of the small dollar size of the loans in the context of an FI’s overall asset
portfolio and the higher costs of collecting information on household borrowers
(consumer loans), most loan decisions made at the retail level tend to be accept
or reject decisions. Regardless of their credit risk, borrowers who are accepted are
often charged the same rate of interest and by implication the same credit risk premium. For example, a wealthy individual borrowing from a credit union to finance
the purchase of a Rolls-Royce is likely to be charged the same auto loan rate as a
less wealthy individual borrowing from that credit union to finance the purchase of
a Honda. In the terminology of finance, retail customers (consumer loans) are more
likely to be sorted or rationed by loan quantity restrictions than by price or interest
rate differences.12 That is, at the retail level an FI controls its credit risks by credit
rationing rather than by using a range of interest rates or prices. Thus, the FI may
offer the wealthy individual a loan of up to $80,000, while the same FI may offer the
less wealthy individual a loan of up to $20,000, both at the same interest rate. Residential mortgage loans provide another good example. While two borrowers may
be accepted for mortgage loans, an FI discriminates between them according to
the loan-to-value ratio—the amount the FI is willing to lend relative to the market
value of the house being acquired—rather than by setting different mortgage rates.
Wholesale
In contrast to the retail level, at the wholesale (C&I) level FIs use both interest rates
and credit quantity to control credit risk. Thus, when FIs quote a prime lending
rate (BR) to C&I borrowers, lower-risk borrowers may be charged a lending rate
below the prime lending rate (i.e., f 0). Higher-risk borrowers are charged a
markup on the prime rate, or a credit (default) risk premium (i.e., f 0), to compensate the FI for the additional credit risk involved.
As long as they are compensated with sufficiently high interest rates (or credit
risk premiums), over some range of credit demand, FIs may be willing to lend
funds to high-risk wholesale borrowers. However, as discussed earlier, increasing loan interest rates (k) may decrease the probability (p) that a borrower will
pay the promised return. For example, a borrower who is charged 15 percent for
a loan—a prime rate of 6 percent plus a credit risk premium of 9 percent—may
be able to make the promised payments on the loan only by using the funds to
invest in high-risk investments with some small chance of a big payoff. However,
12
This does not mean that rates cannot vary across FIs. For example, finance companies associated with
car manufacturers (e.g., GMAC) offered 0.0 percent financing on car loans for much of the 2000s.
Unrecognized by many car buyers, the lenders’ costs of funds were incorporated into an increased price
for the car. Depository institutions, not able to recover their costs of funds in this manner, offered varying
rates in an attempt to compete with finance companies. However, for a given FI, the rate offered on car
loans would be the same for all borrowers.
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by definition, high-risk projects have relatively high probabilities that they will
fail to realize the big payoff. If the big payoff does not materialize, the borrower
may have to default on the loan. In an extreme case, the FI receives neither the
promised interest and fees on the loan nor the original principal lent. This suggests that very high contractual interest rate charges on loans may actually reduce
an FI’s expected return on loans because high interest rates induce the borrower
to invest in risky projects.13 Alternatively, only borrowers that intend to use the
borrowed funds to invest in high-risk projects (high-risk borrowers) may be interested in borrowing from FIs at high interest rates. Low-risk borrowers drop out of
the potential borrowing pool at high-rate levels. This lowers the average quality of
the pool of potential borrowers. We show these effects in Figure 10–4.
At very low contractually promised interest rates (k), borrowers do not need
to take high risks in their use of funds and those with relatively safe investment
projects use FI financing. As interest rates increase, borrowers with fairly lowrisk, low-return projects no longer think it is profitable to borrow from FIs and
drop out of the pool of potential borrowers. Alternatively, borrowers may switch
their use of the borrowed funds to high-risk investment projects to have a (small)
chance of being able to pay off the loan. In terms of Figure 10–4, when interest
rates rise above k* (8 percent), the additional expected return earned by the FI
through higher contractually promised interest rates (k) is increasingly offset by
a lower probability of repayment on the loan (p). In other words, because of the
potential increase in the probability of default when contractually promised loan
rates are high, an FI charging wholesale borrowers loan rates in the 9 to 14 percent
region can earn a lower expected return than will an FI charging 8 percent.
This relationship between contractually promised interest rates and the
expected returns on loans suggests that beyond some interest rate level, it may be
best for the FI to credit ration its wholesale loans, that is, to not make loans or to
FIGURE 10–4
Relationship
between the
Promised Loan Rate
and the Expected
Return on the Loan
Expected return on
loan [p(1 + k ) – 1] percent
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0
1
2
3
4
5
6
7
8
k*
13
9
10
11
12
13
14
15
Contractually
promised loan
rate (k) percent
In the context of the previous section, a high k on the loan reflecting a high base rate (BR) and risk
premium (f) can lead to a lower probability of repayment (p) and thus a lower E(r) on the loan, where
E(r) p(1 k) 1. Indeed, for very high k, the expected return on the loan can become negative.
Chapter 10
Credit Risk: Individual Loan Risk
291
make fewer loans. Rather than seeking to ration by price (by charging higher and
higher risk premiums to borrowers), the FI can establish an upper ceiling on the
amounts it is willing to lend to maximize its expected returns on lending. In the
context of Figure 10–4, borrowers may be charged interest rates up to 8 percent,
with the most risky borrowers also facing more restrictive limits or ceilings on the
amounts they can borrow at any given interest rate.
Concept
Questions
1. Can an FI’s expected return on its loan portfolio increase if it cuts its loan rates?
2. What might happen to the expected return on a wholesale loan if an FI eliminates its
fees and compensating balances in a low–interest rate environment?
MEASUREMENT OF CREDIT RISK
covenants
Restrictions written
into bond and loan
contracts either limiting or encouraging
the borrower’s actions
that affect the probability of repayment.
To calibrate the default risk exposure of credit and investment decisions as well
as to assess the credit risk exposure in off-balance-sheet contractual arrangements
such as loan commitments, an FI manager needs to measure the probability of
borrower default. The ability to do this depends largely on the amount of information the FI has about the borrower. At the retail level, much of the information
needs to be collected internally or purchased from external credit agencies. At
the wholesale level, these information sources are bolstered by publicly available
information, such as certified accounting statements, stock and bond prices, and
analysts’ reports. Thus, for a publicly traded company, more information is produced and is available to an FI than is available for a small, single-proprietor corner store. The availability of more information, along with the lower average cost
of collecting such information, allows FIs to use more sophisticated and usually
more quantitative methods in assessing default probabilities for large borrowers
compared with small borrowers. However, advances in technology and information collection are making quantitative assessments of even smaller borrowers
increasingly feasible and less costly. The simpler details (such as cash flow and
ratio analysis) associated with the measurement of credit risk at the retail and the
wholesale levels are discussed in Appendix 10A, located at the book’s website
(www.mhhe.com/saunders8e).
In principle, FIs can use very similar methods and models to assess the probabilities of default on both bonds and loans. Even though loans tend to involve fewer
lenders to any single borrower as opposed to multiple bondholders, in essence, both
loans and bonds are contracts that promise fixed (or indexed) payments at regular
intervals in the future. Loans and bonds stand ahead of the borrowing firm’s equity
holders in terms of the priority of their claims if things go wrong. Also, bonds, like
loans, include covenants restricting or encouraging various actions to enhance the
probability of repayment. Covenants can include limits on the type and amount of
new debt, investments, and asset sales the borrower may undertake while the loan
or bonds are outstanding. Financial covenants are also often imposed restricting
changes in the borrower’s financial ratios such as its leverage ratio or current ratio.
For example, a common restrictive covenant included in many bond and loan contracts limits the amount of dividends a firm can pay to its equity holders. Clearly,
for any given cash flow, a high dividend payout to stockholders means that less is
available for repayments to bondholders and lenders. Moreover, bond yields, like
wholesale loan rates, usually reflect risk premiums that vary with the perceived
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credit quality of the borrower and the collateral or security backing of the debt.
Given this, FIs can use many of the following models that analyze default risk
probabilities either in making lending decisions or when considering investing in
corporate bonds offered either publicly or privately.
Concept
Questions
1. Is it more costly for an FI manager to assess the default risk exposure of a publicly
traded company or a small, single-proprietor firm? Explain your answer.
2. How do loan covenants help protect an FI against default risk?
DEFAULT RISK MODELS
Economists, analysts, and FI managers have employed many different models to
assess the default risk on loans and bonds. These vary from relatively qualitative
to the highly quantitative models. Further, these models are not mutually exclusive; an FI manager may use more than one model to reach a credit pricing or loan
quantity rationing decision. As will be discussed below in more detail, a great deal
of time and effort has recently been expended by FIs in building highly technical
credit risk evaluation models. Many of these models use ideas and techniques
similar to the market risk models discussed in Chapter 15. We analyze a number
of models in two broad groups: qualitative models and quantitative models.
Qualitative Models
In the absence of publicly available information on the quality of borrowers, the
FI manager has to assemble information from private sources—such as credit and
deposit files—and/or purchase such information from external sources—such as
credit rating agencies. This information helps a manager make an informed judgment on the probability of default of the borrower and price the loan or debt correctly.
In general, the amount of information assembled varies with the size of the
potential debt exposure and the costs of collection. However, a number of key
factors enter into the credit decision. These include (1) borrower-specific factors,
which are idiosyncratic to the individual borrower, and (2) market-specific factors,
which have an impact on all borrowers at the time of the credit decision. The FI
manager then weights these factors subjectively to come to an overall credit decision. Because of their reliance on the subjective judgment of the FI manager, these
models are often called expert systems. Commonly used borrower-specific and
market-specific factors are discussed next.
Borrower-Specific Factors
implicit contract
Long-term customer
relationship between
a borrower and lender
based on reputation.
Reputation The borrower’s reputation involves the borrowing–lending history
of the credit applicant. If, over time, the borrower has established a reputation
for prompt and timely repayment, this enhances the applicant’s attractiveness to
the FI. A long-term customer relationship between a borrower and lender forms
an implicit contract regarding borrowing and repayment that extends beyond the
formal explicit legal contract on which borrower–lender relationships are based.
The importance of reputation, which can be established only over time through
repayment and observed behavior, works to the disadvantage of small, newer borrowers. This is one of the reasons initial public offerings of debt securities by small
firms often require higher yields than do offerings of older, more seasoned firms.
Chapter 10
leverage
The ratio of a borrower’s debt to equity.
Credit Risk: Individual Loan Risk
293
Leverage A borrower’s leverage or capital structure—the ratio of debt to equity—
affects the probability of its default because large amounts of debt, such as bonds
and loans, increase the borrower’s interest charges and pose a significant claim on
its cash flows. As shown in Figure 10–5, relatively low debt–equity ratios may not
significantly impact the probability of debt repayment. Yet beyond some point,
the risk of bankruptcy increases, as does the probability of some loss of interest or
principal for the lender. Thus, highly leveraged firms may find it necessary to pay
higher risk premiums on their borrowings if they are not rationed in the first place.
Volatility of Earnings As with leverage, a highly volatile earnings stream
increases the probability that the borrower cannot meet fixed interest and principal charges for any given capital structure. Consequently, newer firms or firms
in high-tech industries with a high earnings variance over time are less attractive
credit risks than are those with long and more stable earnings histories.
Collateral As discussed earlier, a key feature in any lending and loan-pricing
decision is the degree of collateral, or assets backing the security of the loan. Many
loans and bonds are backed by specific assets should a borrower default on repayment obligations. Mortgage bonds give the bondholder first claim to some specific
piece of property of the borrower, normally machinery or buildings; debentures
give a bondholder a more general and more risky claim to the borrower’s assets.
Subordinated debentures are even riskier because their claims to the assets of
a defaulting borrower are junior to those of both mortgage bondholders and
debenture bondholders. Similarly, loans can be either secured (collateralized) or
unsecured (uncollateralized).14
Market-Specific Factors
The Business Cycle The position of the economy in the business cycle phase is
enormously important to an FI in assessing the probability of borrower default.
For example, during recessions, firms in the consumer durable goods sector that
produce autos, refrigerators, or houses do badly compared with those in the nondurable goods sector producing clothing and foods. People cut back on luxuries
FIGURE 10–5
Relationship
between the
Cost of Debt,
the Probability
of Default, and
Leverage
Probability
of default
0
D/E*
Leverage
100%
(debt–equity ratio)
14
However, collateralized loans are still subject to some default risk unless these loans are significantly
overcollateralized; that is, assets are pledged with market values exceeding the face value of the debt
instrument. There is also some controversy as to whether posting collateral signifies a high- or low-risk
borrower. Arguably, the best borrowers do not need to post collateral since they are good credit risks,
whereas only more risky borrowers need to post collateral. That is, posting collateral may be a signal of
more rather than less credit risk.
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www.federalreserve.gov
www.rmahq.org
Concept
Questions
during a recession, but are less likely to cut back on necessities such as food. Thus,
corporate borrowers in the consumer durable goods sector of the economy are
especially prone to default risk. Because of cyclical concerns, FIs are more likely
to increase the relative degree of credit rationing in recessionary phases. This has
especially adverse consequences for smaller borrowers with limited or no access
to alternative credit markets such as the commercial paper market.
The Level of Interest Rates High interest rates indicate restrictive monetary policy actions by the Federal Reserve. FIs not only find funds to finance their lending
decisions scarcer and more expensive, but also must recognize that high interest rates are correlated with higher credit risk in general. As discussed earlier,
high interest rate levels may encourage borrowers to take excessive risks and/or
encourage only the most risky customers to borrow.
So far, we have delineated just a few of the qualitative borrower- and economyspecific factors an FI manager may take into account in deciding on the probability of default on any loan or bond.15 Rather than letting such factors enter into the
decision process in a purely subjective fashion, the FI manager may weight these
factors in a more objective or quantitative manner. We discuss quantitative models used to measure credit risk next. One frequently used source of much of this
information is the Risk Management Association (RMA). RMA has become a standard reference for thousands of commercial lenders by providing average balance
sheet and income data for more than 400 industries, common ratios computed for
each size group and industry, five-year trend data, and financial statement data
for more than 100,000 commercial borrowers.
1. Make a list of key borrower characteristics you would assess before making a mortgage loan.
2. How should the risk premium on a loan be affected if there is a reduction in a borrower’s leverage?
Quantitative Models
Credit Scoring Models
credit scoring
models
Mathematical models
that use observed
loan applicant’s
characteristics either
to calculate a score
representing the
applicant’s probability
of default or to sort
borrowers into
different default risk
classes.
Credit scoring models are quantitative models that use observed borrower characteristics either to calculate a score representing the applicant’s probability of
default or to sort borrowers into different default risk classes. By selecting and
combining different economic and financial borrower characteristics, an FI manager may be able to:
1.
2.
3.
4.
5.
Numerically establish which factors are important in explaining default risk.
Evaluate the relative degree or importance of these factors.
Improve the pricing of default risk.
Be better able to screen out bad loan applicants.
Be in a better position to calculate any reserves needed to meet expected future
loan losses.
The primary benefit from credit scoring is that credit lenders can more accurately predict a borrower’s performance without having to use more resources.
15
More generally, five Cs of credit that should be included in any subjective (qualitative) credit analysis include
character (willingness to pay), capacity (cash flow), capital (wealth), collateral (security), and conditions
(economic conditions). See Appendix 10A, located at the book’s website (www.mhhe.com/saunders8e).
Chapter 10
Credit Risk: Individual Loan Risk
295
Using these models means fewer defaults and write-offs for lenders. Indeed, many
FIs are implementing credit scoring models as a way to come in accordance with
the Sarbanes–Oxley Act of 2002, which sets guidelines for corporate governance in
several areas, including risk management and control assessment.
To use credit scoring models, the manager must identify objective economic
and financial measures of risk for any particular class of borrower. For consumer
debt, the objective characteristics in a credit scoring model might include income,
assets, age, occupation, and location. For commercial debt, cash flow information
and financial ratios such as the debt–equity ratio are usually key factors. After
data are identified, a statistical technique quantifies, or scores, the default risk
probability or default risk classification.
Credit scoring models include these three broad types: (1) linear probability
models, (2) logit models, and (3) linear discriminant analysis. Appendix 10A to
the chapter (located at the book’s website, www.mhhe.com/saunders8e) looks at
credit scoring models used to evaluate mortgages and consumer loans. In this section we look at credit scoring models used to evaluate commercial loans.
Linear Probability Model and Logit Model The linear probability model uses past
data, such as financial ratios, as inputs into a model to explain repayment experience
on old loans. The relative importance of the factors used in explaining past repayment
performance then forecasts repayment probabilities on new loans. That is, factors
explaining past repayment performance can be used for assessing p, the probability of
repayment discussed earlier in this chapter (a key input in setting the credit premium
on a loan or determining the amount to be lent) and the probability of default (PD).
Briefly, we divide old loans into two observational groups: those that defaulted
(PDi 1) and those that did not default (PDi 0). Then we relate these observations by linear regression to a set of j causal variables (Xij) that reflect quantitative
information about the ith borrower, such as leverage or earnings. We estimate the
model by linear regression of this form:
PDi n
∑ β j Xij error
j1
where j is the estimated importance of the jth variable (e.g., leverage) in explaining past repayment experience.
If we then take these estimated js and multiply them by the observed Xij for a
prospective borrower, we can derive an expected value of PDi for the prospective
borrower. That value can be interpreted as the probability of default for the borrower: E(PDi) (1 pi) expected probability of default, where pi is the probability of repayment on the loan.
EXAMPLE 10–2
Estimating the
Probability of
Repayment on
a Loan Using
Linear Probability
Credit Scoring
Models
Suppose there were two factors influencing the past default behavior of borrowers: the leverage or debt–equity ratio (D/E) and the sales–asset ratio (S/A). Based on past default (repayment) experience, the linear probability model is estimated as:
PDi 0.5( D/Ei ) 0.0525( S / Ai )
Assume a prospective borrower has a D/E 0.3 and an S/A 2.0. Its expected probability
of default (PDi) can then be estimated as:
PDi 0.5(0.3) 0.0525(2.0) 0.045 or 4.5%
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While this technique is straightforward as long as current information on the
Xij is available for the borrower, its major weakness is that the estimated probabilities of default can often lie outside the interval 0 to 1. The logit model overcomes
this weakness by restricting the estimated range of default probabilities from the
linear regression model to lie between 0 and 1. Essentially this is done by plugging the estimated value of PDi from the linear probability model (in our example,
PDi 0.045) into the following formula:
F( PDi ) 1
1 ePDi
where e is exponential (equal to 2.718) and F(PDi) is the logistically transformed
value of PDi.
Linear Discriminant Models While linear probability and logit models project a value for the expected probability of default if a loan is made, discriminant
models divide borrowers into high or low default risk classes contingent on their
observed characteristics (Xj). Similar to linear probability models, linear discriminant models use past data as inputs into a model to explain repayment experience on old loans. The relative importance of the factors used in explaining past
repayment performance then forecasts whether the loan falls into the high or low
default class.
Consider the discriminant analysis model developed by E. I. Altman for publicly traded manufacturing firms in the United States. The indicator variable Z is
an overall measure of the default risk classification of a commercial borrower.16
This in turn depends on the values of various financial ratios of the borrower (Xj)
and the weighted importance of these ratios based on the past observed experience of defaulting versus nondefaulting borrowers derived from a discriminant
analysis model.17
Altman’s discriminant function (credit-classification model) takes the form:
Z 1.2X 1 1.4X 2 3.3X 3 0.6X 4 1.0X 5
where
X1 Working capital18/total assets ratio
X2 Retained earnings/total assets ratio
X3 Earnings before interest and taxes/total assets ratio
X4 Market value of equity/book value of long-term debt ratio
X5 Sales/total assets ratio
According to Altman’s credit scoring model, any firm with a Z score of
less than 1.81 should be considered a high default risk firm; between 1.81 and
2.99, an indeterminant default risk firm; and greater than 2.99, a low default
risk firm.
16
The Z score is a default indicator and is not a direct probability of default (PD) measure.
E. I. Altman, “Managing the Commercial Lending Process,” in Handbook of Banking Strategy, eds.
R. C. Aspinwall and R. A. Eisenbeis (New York: John Wiley & Sons, 1985), pp. 473–510.
18
Working capital is current assets minus current liabilities.
17
Chapter 10
EXAMPLE 10–3
Calculation of
Altman’s Z Score
Credit Risk: Individual Loan Risk
297
Suppose that the financial ratios of a potential borrowing firm take the following values:
X1 0.2
X2 0
X3 0.20
X4 0.10
X5 2.0
The ratio X2 is zero and X3 is negative, indicating that the firm has had negative earnings or
losses in recent periods. Also, X4 indicates that the borrower is highly leveraged. However,
the working capital ratio (X1) and the sales/assets ratio (X5) indicate that the firm is reasonably
liquid and is maintaining its sales volume. The Z score provides an overall score or indicator of
the borrower’s credit risk since it combines and weights these five factors according to their
past importance in explaining borrower default. For the borrower in question:
Z 1.2(0.2) 1.4(0) 3.3(0.20) 0.6(0.10) 1.0(2.0)
0.24 0 0.66 0.06 2.0
1.64
With a Z score less than 1.81 (i.e., in the high default risk region), the FI should not make a
loan to this borrower until it improves its earnings.
There are a number of problems in using the discriminant analysis model to
make credit risk evaluations.19 The first problem is that these models usually discriminate only between two extreme cases of borrower behavior: no default and
default. As discussed in Chapter 7, in the real world various gradations of default
exist, from nonpayment or delay of interest payments (nonperforming assets) to
outright default on all promised interest and principal payments. This problem
suggests that a more accurate or finely calibrated sorting among borrowers may
require defining more classes in the discriminant analysis model.
The second problem is that there is no obvious economic reason to expect that
the weights in the discriminant function—or, more generally, the weights in any
credit scoring model—will be constant over any but very short periods. The same
concern also applies to the variables (Xj). Specifically, because of changing real
and financial market conditions, other borrower-specific financial ratios may
come to be increasingly relevant in explaining default risk probabilities. Moreover,
the linear discriminant model assumes that the Xj variables are independent of
one another.
The third problem is that these models ignore important, hard-to-quantify factors that may play a crucial role in the default or no default decision. For example,
reputation of the borrower and the nature of long-term borrower–lender relationship could be important borrower-specific characteristics, as could macrofactors
such as the phase of the business cycle. These variables are often ignored in credit
scoring models. Moreover, traditional credit scoring models rarely use publicly
available information, such as the prices of outstanding public debt and equity of
the borrower.
A fourth problem relates to default records kept by FIs. Currently, no centralized database on defaulted business loans for proprietary and other reasons exists.
19
Most of these criticisms also apply to the linear probability and logit models.
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Some task forces set up by consortiums of commercial banks, insurance companies, and consulting firms are currently seeking to construct such databases largely
in response to reforms to bank capital requirements (see Chapter 20). However, it
may well be many years before they are developed. This constrains the ability
of many FIs to use traditional credit scoring models (and quantitative models in
general) for larger business loans—although their use for smaller consumer loans,
such as credit card loans, where much better centralized databases exist, is well
established.
Concept
Questions
1. Suppose an estimated linear probability model looked as follows: Z 0.03X1 0.01X2 error, where
X1 Debt − equity ratio
X 2 Total assets Working capital ratio
Suppose, for a prospective borrower, X1 1.5 and X2 3.0. What is the projected
probability of default for the borrower? (7.5%)
2. Suppose X3 0.5 in Example 103. Show how this would change the default risk
classification of the borrower. (Z 3.95)
3. What are two problems in using discriminant analysis to evaluate credit risk?
Newer credit risk models use financial theory and more widely available financial market data to make inferences about default probabilities on debt and loan
instruments. Consequently, these models are most relevant in evaluating loans to
larger borrowers in the corporate sector. This is the area in which a great deal
of current research is taking place by FIs, as noted in Appendixes 11A and 11B.
We next consider a number of these newer approaches or models of credit risk,
including:
1.
2.
3.
4.
Term structure of credit risk approach (also called reduced-form models).
Mortality rate approach.
RAROC models.
Option models (also called structural models since they are based on an economic model of why firms default).
While some of these models focus on different aspects of credit risk, they are
all linked by a strong reliance on modern financial theory and financial market
data.20
Newer Models of Credit Risk Measurement and Pricing
Term Structure Derivation of Credit Risk
www.standardandpoors.com
One market-based method of assessing credit risk exposure and default probabilities is to analyze the risk premiums inherent in the current structure of
yields on corporate debt or loans to similar risk-rated borrowers. Rating agencies such as Standard & Poor’s (S&P) categorize corporate bond issuers into at
20
For further details on these newer models, see A. Saunders and L. Allen, Credit Risk Management: In
and Out of the Financial Crisis, 3rd ed. (New York: John Wiley and Sons, 2010).
Chapter 10
FIGURE 10–6
Corporate and
Treasury Discount
Bond Yield Curves
Credit Risk: Individual Loan Risk
299
Corporate bonds (grade B)
Yield (%)
13%
Treasury strips
10.80%
6%
5.05%
1
www.occ.treas.gov
Treasury strips
and zero-coupon
corporate bonds
Bonds that are created
or issued bearing no
coupons and only a
face value to be paid
on maturity. As such,
they are issued at a
large discount from
face value. (Also
called deep-discount
bonds.)
2
Maturity (years)
least seven major classes according to perceived credit quality.21 The first four
quality ratings—AAA, AA, A, and BBB—indicate investment-quality borrowers.
The Office of the Comptroller of the Currency, which regulates national banks,
restricts the ability of banks to purchase securities rated outside these classes. By
comparison, insurance company regulators have permitted these FIs to purchase
noninvestment-grade securities with ratings such as BB, B, and CCC, but with
restrictions on the aggregate amounts they can include in their portfolios. These
three classes are known as high-yield or junk bonds. Different quality ratings are
reflected in the degree to which corporate bond yields exceed those implied by the
Treasury (credit risk–free) yield curve.
Look at the spreads shown in Figure 10–6 for zero-coupon corporate (grade B)
bonds over similar maturity zero-coupon Treasuries (called Treasury strips).
Because Treasury strips and zero-coupon corporate bonds are single-payment
discount bonds, it is possible to extract required credit risk premiums and implied
probabilities of default from actual market data on interest rates. That is, the
spreads between risk-free discount bonds issued by the Treasury and discount
bonds issued by corporate borrowers of differing quality reflect perceived credit
risk exposures of corporate borrowers for single payments at different times in
the future. FIs can use these credit risk probabilities on existing debt to decide
whether or not to issue additional debt to a particular credit risk borrower. Note
that in market-based models of assessing default risk, FIs use information on
credit quality processed by rating agencies rather than by the FI itself. Thus, the
use of market-based models abstracts the FI’s role as an information processor.
Rather, the unique role played by the FI is to process market-based information to
assess default probabilities.
21
Rating agencies consider several factors in determining and assigning credit ratings on bond issues.
For example, a financial analysis is conducted of the issuer’s operations and its needs, its position in
the industry, and its overall financial strength and ability to pay the required interest and principal on
the bonds. Rating agencies analyze the issuer’s liquidity, profitability, debt capacity, and, more recently,
corporate governance structure (following the passage of the Sarbanes–Oxley Act in 2002). Then for
each particular issue, rating agencies evaluate the nature and provisions of the debt issue (e.g., covenants
and callability of the bond) and the protection afforded by, and relative position of, the debt issue in the
event of bankruptcy, reorganization, or other arrangements under the laws of bankruptcy and other laws
affecting creditors’ rights.
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Part Two
Measuring Risk
Next, we look at the simplest case of extracting an implied probability of default
for an FI considering buying one-year bonds from or making one-year loans to a
risky borrower. Then, we consider multiyear loans and bonds. In each case, we
show that we can extract a market view of the credit risk—the expected probability of default—of an individual borrower.
Probability of Default on a One-Period Debt Instrument Assume that the FI
requires an expected return on a one-year (zero-coupon) corporate debt security
equal to at least the risk-free return on one-year (zero-coupon) Treasury strips. Let
p be the probability that the corporate debt will be repaid in full; therefore, 1 p is
the probability of default. If the borrower defaults, the FI is (for now) assumed to
get nothing (i.e., the recovery rate is zero or the loss given default is 100 percent).22
By denoting the contractually promised return on the one-year corporate debt strip
as 1 k and on the credit risk–free one-year Treasury strip as 1 i, the FI manager
would just be indifferent between corporate and Treasury securities when:23
p (1 k ) 1 i
or, the expected return on corporate securities is equal to the risk-free rate.
EXAMPLE 10–4
Calculating the
Probability of
Default on a
One-Year Bond
(Loan) Using
Term Structure
Derivation of
Credit Risk
Suppose, as shown in Figure 10–6, the interest rates in the market for one-year, zero-coupon
Treasury strips and for one-year, zero-coupon grade B corporate bonds are, respectively:
i 5.05%
and
k 10.80%
This implies that the probability of repayment on the security as perceived by the market is:
p 1 i
1.0505
0.948
1 k
1.1080
If the probability of repayment is 0.948, this implies a probability of default (1 p) equal
to 0.052. Thus, in this simple one-period framework, a probability of default of 5.2 percent
on the corporate bond (loan) requires the FI to set a risk premium (f) of 5.75 percent.24
k i 5.75%
Clearly, as the probability of repayment (p) falls and the probability of default (1 p)
increases, the required spread f between k and i increases.
22
This is a key assumption. If the recovery rate is nonzero (which in reality is true, since in recent years banks
have recovered, on average, over 80 percent of a defaulted loan and 60 percent of a senior secured bond),
then the spread between the corporate bond return and the Treasury security return will reflect both the
probability of default (PD) as well as the loss given default (the latter is equal to 1 minus the recovery rate).
To disentangle the probability of default from the loss given default, we need to make assumptions about
the size of the loss given default (LGD) or the statistical process that either the PD and/or the LGD follow,
such as the Poisson process. One simple case assuming LGD is known is discussed later in this chapter.
23
This assumes that the FI manager is not risk averse; that is, this is a risk-neutral valuation method and
the probabilities so derived are called risk-neutral probabilities. In general these will differ from probabilities estimated from historic data on defaults. See Saunders and Allen, Credit Risk Management, chap. 5.
24
In the real world an FI could partially capture this required spread in higher fees and compensating balances rather than only in the risk premium. In this simple example, we are assuming away compensating
balances and fees. However, they could easily be built into the model.
Chapter 10
TABLE 10–8
Recovery Rates (RR)
on Defaulted Debt
Source: E. I. Altman,
“Default Recovery Rates
and LGD in Credit Risk
Modeling and Practice,”
Working Paper, New York
University Salomon Center,
January 2012.
Type of Debt
Bank debt
Revolving loans
Term loans
Senior secured bonds
Senior unsecured bonds
Senior subordinated bonds
Subordinated bonds
Credit Risk: Individual Loan Risk
301
Recovery Rate
Number of Observations
82.24%
85.63
56.34
62.00
43.80
30.50
28.80
1,156
1,034
122
320
863
489
399
This analysis can easily be extended to the more realistic case in which the
FI does not expect to lose all interest and all principal if the corporate borrower
defaults. Realistically, the FI lender can expect to receive some partial repayment
even if the borrower goes into bankruptcy. For example, Altman estimated that
when firms defaulted on their bonds in 2011, the investor lost on average 63.3
cents on the dollar (i.e., recovered around 36.7 cents on the dollar).25 Table 10–8
gives recovery rates on defaulted debt by type of debt from 1988 to 2010. As discussed earlier in this chapter, many loans and bonds are secured or collateralized by first liens on various pieces of property or real assets should a borrower
default. Note that secured loans experienced the highest recovery rates among the
corporate bonds listed (62.00 percent).
Let be the proportion of the loan’s principal and interest that is collectible on
default, where in general is positive. The FI manager would set the expected
return on the loan to equal the risk-free rate in the following manner:
[(1 p)γ (1 k )] [ p(1 k )] 1 i
The new term here is (1 p) (1 k); this is the payoff the FI expects to get if the
borrower defaults.
As might be expected, if the loan has collateral backing such that 0, the
required risk premium on the loan will be less for any given default risk probability (1 p). Collateral requirements are a method of controlling default risk. They
act as a direct substitute for risk premiums in setting required loan rates. To see
this, solve for the risk premium f between k (the required yield on risky corporate
debt) and i (the risk-free rate of interest):
ki (1 i)
(1 i)
( γ p pγ )
If i 5.05 percent and p 0.948 as before but the FI can expect to collect 90
percent of the promised proceeds if default occurs ( 0.9), then the required risk
premium f 0.55 percent.
Interestingly, in this simple framework,
and p are perfect substitutes for
each other. That is, a bond or loan with collateral backing of 0.95 and p 0.9
would have the same required risk premium as one with 0.9 and p 0.95. An
increase in collateral is a direct substitute for an increase in default risk (i.e., a
decline in p).
25
E. I. Altman, “Current Conditions and Outlook on Global Sovereign and Corporate Credit Markets,”
Working Paper, New York University Salomon Center, February 2012.
302
Part Two
Measuring Risk
marginal default
probability
The probability that a
borrower will default
in any given year.
cumulative default
probability
The probability that a
borrower will default
over a specified multiyear period.
Probability of Default on a Multiperiod Debt Instrument We can extend this
type of analysis to derive the credit risk or default probabilities occurring in the
market for longer-term loans or bonds (i.e., two-year bonds). To do this, the manager must estimate the probability that the bond will default in the second year
conditional on the probability that it does not default in the first year. The probability that a bond will default in any given year is clearly conditional on the fact
that the default has not occurred earlier. The probability that a bond will default
in any given year, t, is the marginal default probability for that year, 1 pt. However, for, say, a two-year loan, the marginal probability of default in the second
year (1 p2) can differ from the marginal probability of default in the first year
(1 p1). If we use these marginal default probabilities, the cumulative default
probability at some time between now and the end of year 2 is:
Cp 1 [( p1 )( p2 )]
EXAMPLE 10–5
Calculating
the Probability
of Default on
a Multiperiod
Bond
Suppose the FI manager wants to find out the probability of default on a two-year loan. For
the one-year loan, 1 p1 0.05 is the marginal and total or cumulative probability (Cp) of
default in year 1. Later in this chapter we discuss ways in which p2 can be estimated by the FI
manager, but for the moment suppose that 1 p2 0.07. Then:
1 p1 .05 marginal probability of default in year 1
1 p2 .07 marginal probability of default in year 2
The probability of the borrower surviving—not defaulting at any time between now (time 0)
and the end of period 2—is p1 p2 (0.95)(0.93) 0.8835.
Cp 1 [(0.95)(0.93)] 0.1165
There is an 11.65 percent probability of default over this period.
no arbitrage
The inability to make
a profit without
taking risk.
forward rate
A one-period rate of
interest expected on a
bond issued at some
date in the future.
We have seen how to derive the one-year probability of default from yield
spreads on one-year bonds. We now want to derive the probability of default in
year 2, year 3, and so on. Look at Figure 10–6; as you can see, yield curves are rising for both Treasury issues and corporate bond issues. We want to extract from
these yield curves the market’s expectation of the multiperiod default rates for corporate borrowers classified in the grade B rating class.26
Look first at the Treasury yield curve. The condition of efficient markets and
thus no arbitrage profits by investors requires that the return on buying and holding the two-year Treasury strip (T-strip) to maturity just equals the expected return
from investing in the current one-year discount T-strip and reinvesting the principal and interest in a new one-year discount T-strip at the end of the first year at the
expected one-year forward rate. That is:
(1 i2 )2 (1 i1 )(1 f1 )
26
(1)
To use this model, one has to place borrowers in a rating class. One way to do this for unrated firms
would be to use the Z score model to calculate a Z ratio for this firm. E. I. Altman has shown that there
is a high correlation between Z scores and Standard & Poor’s and Moody’s bond ratings. Once a firm is
placed in a bond rating group (e.g., B) by the Z score model, the term structure model can be used to
infer the expected (implied) probabilities of default for the borrower at different times in the future.
Chapter 10
Credit Risk: Individual Loan Risk
303
The term on the left side is the return from holding the two-year Treasury strip
to maturity. The term on the right side results from investing in two successive oneyear T-strips, where i1 is the current one-year T-strips rate and f1 is the expected
one-year T-strip rate or forward rate next year. Since we can observe directly from
the T-strip yield curve the current required yields on one- and two-year Treasuries, we can directly infer the market’s expectation of the one-year Treasury strip
rate next period or the one-year forward rate, f1:
1 f1 (1 i2 )2
(1 i1 )
(2)
We can use the same type of analysis with the corporate bond yield curve to
infer the one-year forward rate on corporate bonds (grade B in this example). The
one-year rate expected on corporate securities (c1) one year into the future reflects
the market’s default risk expectations for this class of borrower as well as the more
general time value factors also affecting f1:
1 c1 (1 k2 )2
(1 k1 )
(3)
The expected rates on one-year bonds can generate an estimate of the expected
probability of repayment on one-year corporate bonds in one year’s time, or what
we have called p2. Since:
p2 (1 c1 ) 1 f1
then:
⎡ 1 f1 ⎤
p2 ⎢
⎥
⎣ 1 c1 ⎦
(4)
Thus, the expected probability of default in year 2 is:
1 p2
(5)
In a similar fashion, the one-year rates expected in two years’ time can be derived
from the Treasury and corporate term structures so as to derive p3, and so on.
EXAMPLE 10–6
Calculating
the Probability
of Default on
a Multiperiod
Bond Using
Term Structure
Derivation of
Credit Risk
From the Treasury strip yield curve in Figure 10–6, the current required yields on one- and twoyear Treasuries are i1 5.05 percent and i2 6 percent, respectively. If we use equation (2),
the one-year forward rate, f1, is:
1 f1 (1.06)2
1.0696
(1.0505)
or
f1 6.96%
The expected rise in one-year rates from 5.05 percent (i1) this year to 6.96 percent (f1) next
year reflects investors’ perceptions regarding inflation and other factors that directly affect
the time value of money.
304
Part Two
Measuring Risk
Further, the current yield curve, in Figure 10–6, indicates that appropriate one-year discount bonds are yielding k1 10.80 percent and two-year bonds are yielding k2 13 percent. Thus, if we use equation (3), the one-year rate expected on corporate securities, c1, is:
1 c1 (1.13)2
1.1524
(1.1080)
or
c 1 15.24%
We summarize these calculations in Table 10–9. As you can see, the expected spread
between one-year corporate bonds and Treasuries in one year’s time is higher than the spread
for current one-year bonds. Thus, the default risk premium increases with the maturity on the
corporate (risky) bond.
From these expected rates on one-year bonds, if we use equations (4) and (5), the expected
probability of repayment on one-year corporate bonds in one year’s time, p2, is:
p2 [1.0696]
0.9281
[1.1524]
and the expected probability of default in year 2 is:
1 p2 1 0.9281 0.0719
or
7.19%
The probabilities we have estimated are marginal probabilities conditional on
default not occurring in a prior period. We also discussed the concept of the cumulative probability of default that would tell the FI the probability of a loan or bond
investment defaulting over a particular time period. In the example developed
earlier, the cumulative probability that corporate grade B bonds would default
over the next two years is:
Cp 1 [(p1 )(p2 )]
Cp 1 [(0.948)(0.9281)] 12.02%
As with the credit scoring approach, this model creates some potential problems. Its principal advantages are that it is clearly forward-looking and based on
market expectations. Moreover, if there are liquid markets for Treasury and corporate discount bonds—Treasury strips and corporate zero-coupon bonds—then we
can easily estimate expected future default rates and use them to value and price
loans. However, while the market for Treasury strips is now quite deep, the market for corporate discount bonds is quite small. Although a discount yield curve
TABLE 10–9
Treasury and
Corporate Rates and
Rate Spreads
Current One-Year Rate
Treasury
Corporate (B)
Spread
5.05%
10.80
5.75
Expected One-Year Rate
6.96%
15.24
8.28
Chapter 10
Credit Risk: Individual Loan Risk
305
for corporate bonds could be extracted mathematically from the corporate bond
coupon yield curve, these bonds often are not very actively traded and prices are
not very transparent. Given this, the FI manager might have to consider an alternative way to use bond or loan data to extract default rate probabilities for all but
the very largest corporate borrowers. We consider a possible alternative next.
Concept
Questions
1. What is the difference between the marginal default probability and the cumulative
default probability?
2. How should the posting of collateral by a borrower affect the risk premium on a loan?
Mortality Rate Derivation of Credit Risk
mortality rate
Historic default rate
experience of a bond
or loan.
marginal mortality
rate
The probability of a
bond or loan defaulting in any given year
after issue.
FIGURE 10–7
Hypothetical
Marginal Mortality
Rate Curve for
Grade B Corporate
Bonds
Rather than extracting expected default rates from the current term structure of interest rates, the FI manager may analyze the historic or past default risk experience, the
mortality rates, of bonds and loans of a similar quality. Consider calculating p1 and
p2 using the mortality rate model. Here p1 is the probability of a grade B bond or
loan surviving the first year of its issue; thus 1 p1 is the marginal mortality rate,
or the probability of the bond or loan defaulting in the first year of issue. While p2
is the probability of the loan surviving in the second year given that default has not
occurred during the first year, 1 p2 is the marginal mortality rate for the second
year. Thus, for each grade of corporate borrower quality, a marginal mortality
rate (MMR) curve can show the historical default rate experience of bonds in any
specific quality class in each year after issue on the bond or loan.
Note in Figure 10–7 that as grade B bonds age, their probability of default
increases in each successive year. Of course, in reality, any shape to the mortality curve is possible. It is possible that MMRs can be flat, decline over time, or
show a more complex functional form. These marginal mortality rates can be estimated from actual data on bond and loan defaults. Specifically, for grade B quality
bonds (loans):
MMR1 Total value of grade B bonds defaulting in year 1 of issue
Total value of grade B bonds outstanding in year 1 of issue
MMR2 Total value of grade B bonds defaulting in year 2 of issue
Total value of grade B bonds outstanding in year 2 of issue
adjusted for defaults, calls, sinking fund redemptions, and
maturities in the prior year
Marginal
mortality rate
(MMR)
MMR5
MMR4
MMR3
MMR2
MMR1
0
1
2
3
4
5
Years since issue
306
Part Two
Measuring Risk
TABLE 10–10 Mortality Rates by Original Rating—All Rated* Corporate Bonds, 1971–2011
Source: E. I. Altman and B. J. Kuehne, “Special Report on Default and Returns in the High-Yield Bond and Distressed Debt Market: The Year 2011 in Review
and Outlook,” New York University Salomon Center, February 2012.
Years after Issuance
AAA Marginal
Cumulative
AA Marginal
Cumulative
A
Marginal
Cumulative
BBB Marginal
Cumulative
BB
Marginal
Cumulative
B
Marginal
Cumulative
CCC Marginal
Cumulative
1
2
3
4
5
6
7
8
9
10
0.00% 0.00% 0.00% 0.00% 0.02% 0.02% 0.01% 0.00% 0.00% 0.00%
0.00% 0.00% 0.00% 0.00% 0.02% 0.04% 0.05% 0.05% 0.05% 0.05%
0.00% 0.00% 0.25% 0.11% 0.02% 0.02% 0.01% 0.01% 0.03% 0.01%
0.00% 0.00% 0.25% 0.36% 0.38% 0.40% 0.41% 0.42% 0.45% 0.46%
0.01% 0.06% 0.16% 0.17% 0.14% 0.10% 0.04% 0.30% 0.11% 0.07%
0.01% 0.07% 0.23% 0.40% 0.54% 0.64% 0.68% 0.98% 1.09% 1.15%
0.38% 2.49% 1.37% 1.05% 0.58% 0.27% 0.30% 0.17% 0.16% 0.36%
0.38% 2.86% 4.19% 5.20% 5.75% 6.00% 6.28% 6.44% 6.59% 6.93%
1.01% 2.07% 3.95% 2.00% 2.42% 1.47% 1.51% 1.10% 1.50% 3.20%
1.01% 3.06% 6.89% 8.75% 10.96% 12.27% 13.59% 14.54% 15.82% 18.52%
2.96% 7.86% 7.95% 7.93% 5.84% 4.58% 3.66% 2.15% 1.83% 0.82%
2.96% 10.59% 17.70% 24.22% 28.65% 31.92% 34.41% 35.82% 36.99% 37.51%
8.30% 12.65% 18.28% 16.35% 4.82% 11.78% 5.45% 4.95% 0.70% 4.41%
8.30% 19.90% 34.54% 45.24% 47.88% 54.02% 56.53% 58.68% 58.97% 60.78%
*Rated by S&P at issuance. Based on 2,644 issues.
Table 10–10 shows the estimated mortality and cumulative default rates for
samples of 2,644 rated corporate bonds over the 1971–2011 period. From Table
10–10 it can be seen that mortality rates are higher the lower the rating of the
bond. For example, between 1971 and 2011, there was a 1.15 percent probability
that A-rated bonds would default over the 10 years after issue and a 37.51 percent
probability that B-rated bonds would default over the 10 years after issue.
The mortality rate approach has a number of conceptual and applicability
problems. Probably the most important of these is that, like the credit scoring
model, it produces historic, or backward-looking, measures. Also, the estimates of
default rates and therefore implied future default probabilities tend to be highly
sensitive to the period over which the FI manager calculates the MMRs. For example, WorldCom had an S&P rating of BBB just prior to its defaulting on its debt
in 2002. Note in Table 10–10 the second year’s marginal mortality rate for BBB
bonds (2.49 percent) is much higher than those of years 3 and 4 (1.37 percent and
1.05 percent, respectively) and is even higher than that of the second-year mortality rate for BB bonds (2.07 percent). This is primarily due to the default of WorldCom in 2002. In addition, the estimates tend to be sensitive to the number of issues
and the relative size of issues in each investment grade.27
Concept
Questions
1. In Table 10–10, the CMR over 3 years for CCC-rated corporate bonds is 34.54 percent.
Check this calculation using the individual year MMRs.
2. Why would any FI manager buy loans that have a CMR of 34.54 percent? Explain
your answer.
27
For example, even though the estimates in Table 10–10 are based on 2,644 observations of bonds,
these estimates still have quite wide confidence bands. See Saunders and Allen, Credit Risk Management.
Chapter 10
Credit Risk: Individual Loan Risk
307
RAROC Models
RAROC
Risk-adjusted return
on capital.
An increasingly popular model used to evaluate (and price) credit risk based on
market data is the RAROC model. The RAROC (risk-adjusted return on capital)
was pioneered by Bankers Trust (acquired by Deutsche Bank in 1998) and has now
been adopted by virtually all the large banks in the United States and Europe,
although with some significant proprietary differences between them.
The essential idea behind RAROC is that rather than evaluating the actual or
contractually promised annual ROA on a loan, as earlier in the chapter (that is, net
interest and fees divided by the amount lent), the lending officer balances expected
interest and fee income less the cost of funds against the loan’s expected risk. Thus,
the numerator of the RAROC equation is net income (accounting for the cost of funding the loan) on the loan. Further, rather than dividing annual loan income by assets
lent, it is divided by some measure of asset (loan) risk or what is often called capital
at risk, since (unexpected) loan losses have to be written off against an FI’s capital:28
RAROC One year net income on a loan
Loan (asset) risk or capital at risk
A loan is approved only if RAROC is sufficiently high relative to a benchmark
return on capital (ROE) for the FI, where ROE measures the return stockholders
require on their equity investment in the FI. The idea here is that a loan should
be made only if the risk-adjusted return on the loan adds to the FI’s equity value
as measured by the ROE required by the FI’s stockholders. Thus, for example, if
an FI’s ROE is 10 percent, a loan should be made only if the estimated RAROC is
higher than the 10 percent required by the FI’s stockholders as a reward for their
investment in the FI. Alternatively, if the RAROC on an existing loan falls below
an FI’s RAROC benchmark, the lending officer should seek to adjust the loan’s
terms to make it “profitable” again. Therefore, RAROC serves as both a credit risk
measure and a loan pricing tool for the FI manager.
The numerator of the RAROC equation is relatively straightforward to estimate. Specifically,
One year net income on loan (Spread Fees)
Dollar value of the loan outstanding
FIs may deduct any overhead and tax expenses as well to get the one year net
income on the loan. However, a more difficult problem in estimating RAROC is
the measurement of loan risk (the denominator in the RAROC equation). Two
methods of estimating loan risk involve the use of a duration model and the use
of loan default rates.
Using Duration to Estimate Loan Risk Chapter 9 on duration showed that the
percentage change in the market value of an asset such as a loan (ΔLN/LN) is related
to the duration of the loan and the size of the interest rate shock (ΔR/(1 R)), where
R is the base rate, BR, plus the credit risk premium, f:
LN
R
DLN
1R
LN
28
Traditionally, expected loan losses are covered by an FI’s loss reserve (or provisions), while unexpected
or extreme loan losses are being met by an FI’s capital reserves.
308
Part Two
Measuring Risk
The same concept is applied here, except that (assuming that the base rate remains
constant) interest rate shocks are the consequence of credit quality (or credit risk
premium) shocks (i.e., shocks to f). We can thus rewrite the duration equation
with the following interpretation to estimate the loan risk or capital at risk on
the loan:
LN
(dollar capital
risk exposure
or loss amount)
EXAMPLE 10–7
Calculation of
RAROC on a
Loan
DLN
(duration of
the loan)
LN
(risk amount or
size of loan)
( R/(1 R))
(expected maximum
change in the loan rate
due to a change in the
credit risk premium ( ) or
risk factor on the loan)
Suppose an FI wants to evaluate the credit risk of a $1 million loan with a duration of
2.7 years to a AAA borrower. Assume there are currently 400 publicly traded bonds in that
class (i.e., bonds issued by firms of a rating type similar to that of the borrower). The first step
is to evaluate the actual changes in the credit risk premiums (Ri RG) on each of these bonds
for the past year (in this example, the year 2015). These (hypothetical) changes are plotted
in the frequency curve of Figure 10–8. They range from a fall in the risk premiums of negative 2 percent to an increase of 3.5 percent. Since the largest increase may be a very extreme
(unrepresentative) number, the 99 percent worst-case scenario is chosen (i.e., only 4 bonds
out of 400 had risk premium increases exceeding the 99 percent worst case). For the example
shown in Figure 10–8 this is equal to 1.1 percent.
The estimate of loan (or capital) risk, assuming that the current average level of rates (R)
on AAA bonds is 5 percent, is:
R
1+ R
⎛ 0.011⎞
(2.7)($1million) ⎜
⎝ 1.05 ⎟⎠
LN DLN × LN ×
$28,286
While the market value of the loan amount is $1 million, the risk amount, or change in the
loan’s market value due to a decline in its credit quality, is $28,286. Thus, the denominator of
the RAROC equation is this possible loss, or $28,286.
To determine whether the loan is worth making, the estimated loan risk is compared with
the loan’s income (spread over the FI’s cost of funds plus fees on the loan). Suppose the projected (one-year) spread plus fees is as follows:
Spread 0.2% $1 million $2, 000
Fees 0.1% $1 million $1, 000
$3, 000
The loan’s RAROC is:
RAROC One year net income on loan
$3,000
= 10.61%
Loan risk (or capital risk)( LN )
$28,286
Note that RAROC can be either forward looking, comparing the projected
income over the next year on the loan with ΔLN, or backward looking, comparing
the actual income generated on the loan over the past year with ΔLN. If the 10.61
Chapter 10
FIGURE 10–8
Credit Risk: Individual Loan Risk
309
Frequency
Hypothetical
Frequency
Distribution of
Yield Spread
Changes for All
AAA Bonds in 2015
1% of all AAA bonds
– Risk – 2%
premium
0
+1.1%
+3.5% + Risk
premium
percent exceeds the FI’s internal RAROC benchmark (based on its cost of capital,
or ROE), the loan will be approved. If it is less, the loan will be rejected outright or
the borrower will be asked to pay higher fees and/or a higher spread to increase
the RAROC to acceptable levels.
While the loan’s duration (2.7 years in our example) and the loan amount ($1
million) are easily estimated, it is more difficult to estimate the maximum change
in the credit risk premium on the loan over the next year. Since publicly available
data on loan risk premiums are scarce, we turn to publicly available corporate
bond market data to estimate premiums. First, an S&P credit rating (AAA, AA,
A, and so on) is assigned to a borrower. Thereafter, the available risk premium
changes of all the bonds traded in that particular rating class over the last year are
analyzed. The ΔR in the RAROC equation equals:
R Max [ (Ri RG ) 0]
where Δ(Ri RG) is the change in the yield spread between corporate bonds of
credit rating class i (Ri) and matched duration Treasury security (RG) over the last
year. In order to consider only the worst-case scenario, a maximum change in
yield spread is chosen, as opposed to the average change. In general, it is common
to pick the 1 percent worst case or 99th percentile of credit risk changes.
Using Loan Default Rates to Estimate Loan Risk Other FIs have adopted different ways of calculating ΔLN in their versions of RAROC. Some FIs, usually the
largest ones with very good loan default databases, divide one-year income by the
product of an unexpected loss rate and the proportion of the loan lost on default,
also called the loss given default. Thus:
RAROC One-year net income per dollar loaned
Unexpected default rate Proportion of loan lost on default (loss given default)
Suppose expected income per dollar lent is 0.3 cents, or 0.003. The 99th percentile historic (extreme case) default rate for borrowers of this type is 4 percent,
310
Part Two
Measuring Risk
and the dollar proportion of loans of this type that cannot be recaptured is 80
percent. Then:29
RAROC Concept
Question
0.003
0.003
9.375%
(0.04)(0.8)
(0.032)
1. Describe the basic concept behind RAROC models.
Option Models of Default Risk
Theoretical Framework In recent years, following the pioneering work of Nobel
Prize winners Merton, Black, and Scholes, we now recognize that when a firm
raises funds by issuing bonds or increasing its bank loans, it holds a very valuable
default or repayment option.30 That is, if a borrower’s investment projects fail so
that it cannot repay the bondholder or the bank, it has the option of defaulting
on its debt repayment and turning any remaining assets over to the debtholder.
Because of limited liability for equity holders, the borrower’s loss is limited on
the downside by the amount of equity invested in the firm. On the other hand, if
things go well, the borrower can keep most of the upside returns on asset investments after the promised principal and interest on the debt have been paid. The
KMV Corporation (which was purchased by Moody’s in 2002 and is now part
of Moody’s Analytics Enterprise Risk Solutions) turned this relatively simple
idea into a credit monitoring model. Many of the largest U.S. FIs are now using
this model to determine the expected default risk frequency (EDF) of large corporations.31 Before we look at the Moody’s Analytics Credit Monitor model, we
will take a closer look at the theory underlying the option approach to default
risk estimation. Appendix 10B, located at the book’s website (www.mhhe.com/
saunders8e), reviews the Black–Scholes option pricing model.
The Borrower’s Payoff from Loans Look at the payoff function for the borrower
in Figure 10–9, where S is the size of the initial equity investment in the firm, B is
the value of outstanding bonds or loans (assumed for simplicity to be issued on a
discount basis), and A is the market value of the assets of the firm.
If the investments in Figure 10–9 turn out badly such that the firm’s assets
are valued at point A1, the limited-liability stockholder–owners of the firm will
default on the firm’s debt, turn its assets (such as A1) over to the debt holders, and
lose only their initial stake in the firm (S). By contrast, if the firm does well and the
29
Calculating the unexpected default rate commonly involves calculating the standard derivation ( ) of
annual default rates on loans of this type and then multiplying by a factor such that 99 percent (or
higher) of defaults are covered by capital. For example, if the loss distribution was normally distributed,
then the of default rates would be multiplied by 2.33 to get the extreme 99 percent default rate. For
many FIs, default rates are skewed to the right and have fat tails suggesting a multiplier much larger than
2.33. For example, to get coverage of 99.97 percent of defaults, Bank of America has historically used
a multiplier of 6. Finally, the denominator can also be adjusted for the degree of correlation of the loan
with the rest of the FI’s portfolio.
30
R. C. Merton, “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,” Journal of
Finance 29 (1974), pp. 449–70; and F. Black and M. Scholes, “The Pricing of Options and Corporate
Liabilities,” Journal of Political Economy 81 (1973), pp. 637–59.
31
See KMV Corporation Credit Monitor, KMV Corporation, San Francisco, 1994; and Saunders and Allen,
Credit Risk Measurement, chap. 4.
Chapter 10
FIGURE 10–9
Payoff Function
to Corporate
Borrowers
(Stockholders)
Credit Risk: Individual Loan Risk
311
Payoff to
stockholders
0
A1
B (debt)
A2 Assets (A)
–S
assets of the firm are valued highly (A2), the firm’s stockholders will pay off the
firm’s debt and keep the difference (A2 B). Clearly, the higher A2 is relative to B,
the better off are the firm’s stockholders. Given that borrowers face only a limited
downside risk of loss of their equity investment, but a very large potential upside
return if things turn out well, equity is analogous to buying a call option on the
assets of the firm (see also Chapter 23 on options).
The Debt Holder’s Payoff from Loans Consider the same loan or bond issue
from the perspective of the FI or bondholder. The maximum amount the FI or
bondholder can get back is B, the promised payment. However, the borrower who
possesses the default or repayment option would rationally repay the loan only
if A B, that is, if the market value of assets exceeds the value of promised debt
repayments. A borrower whose asset value falls below B would default and turn
over any remaining assets to the debt holders. The payoff function to the debt
holder is shown in Figure 10–10.
After investment of the borrowed funds has taken place, if the value of the firm’s
assets lies to the right of B, the face value of the debt—such as A2—the debt holder
or FI will be paid off in full and receive B. On the other hand, if asset values fall in
the region to the left of B—such as A1—the debt holder will receive back only those
assets remaining as collateral, thereby losing B A1. Thus, the value of the loan
from the perspective of the lender is always the minimum of B or A, or min [B, A].
That is, the payoff function to the debt holder is similar to writing a put option on
the value of the borrower’s assets with B, the face value of debt, as the exercise price.
If A B, the loan is repaid and the debt holder earns a small fixed return (similar
to the premium on a put option), which is the interest rate implicit in the discount
FIGURE 10–10
Payoff Function to
the Debt Holder
(the FI) from a Loan
Payoff to
debt holders
B
0
A1
B (debt)
A2
Assets (A)
312
Part Two
Measuring Risk
bond. If A B, the borrower defaults and the debt holder stands to lose both interest and principal. In the limit, default for a firm with no assets left results in debt
holders’ losing all their principal and interest. In actuality, if there are also costs of
bankruptcy, the debt holder can potentially lose even more than this.
Applying the Option Valuation Model to the Calculation of Default Risk
Premiums Merton has shown that in the context of the preceding options framework, it is quite straightforward to express the market value of a risky loan made
by a lender to a borrower as:32
F(τ) Beiτ [(1/ d)N ( h1 ) N ( h2 )]
(6)
where
Length of time remaining to loan maturity; that is, T t, where T
is the maturity date and time t is today.
d Borrower’s leverage ratio measured as Bei /A, where the market
value of debt is valued at the rate i, the risk-free rate of interest.
N(h) Value computed from the standardized normal distribution statistical
tables. This value reflects the probability that a deviation exceeding the
calculated value of h will occur.
2
h1 ⎡⎣( 1 2 )
2
ln(d) ⎤⎦ /
h2 ⎡⎣( 1 2 )
2
ln(d) ⎤⎦ /
Measures the asset risk of the borrower. Technically, it is the variance of
the rate of change in the value of the underlying assets of the borrower.
Written in terms of a yield spread, , this equation reflects an equilibrium default
risk premium that the borrower should be charged:
k( ) i (1/ ) ln[ N ( h2 ) (1/ d)N ( h1 )]
where
k( ) Required yield on risky debt (the contractually promised return from
earlier)
ln Natural logarithm
i Risk-free rate on debt of equivalent maturity (here, one period)
Thus, Merton has shown that the lender should adjust the required risk premium
as d and 2 change, that is, as leverage and asset risk change.
EXAMPLE 10–8
Calculating the
Value of and
Interest Rate on
a Loan Using the
Option Model
Suppose that:
B $100,000
1 year
i 5%
d 90% or 0.9
12%
32
See Merton, “On the Pricing of Corporate Debt.”
Chapter 10
Credit Risk: Individual Loan Risk
313
That is, suppose we can measure the market value of a firm’s assets (and thus d Bei /A) as
well as the volatility of those assets ( ). Then, substituting these values into the equations for
h1 and h2 and solving for the areas under the standardized normal distribution, we find that:
N (h1) 0.174120
N (h2 ) 0.793323
where
h1 [ 12 (0.12)2 (1) ln(0.9)]
0.938
0.12
and
h2 [
1
2
(0.12)2 (1) ln(0.9)]
0.818
0.12
The current market value of the loan is:
L(t ) Bei [N (h2 ) (1/d )N (h1)]
$100,000
[0.793323 (1.1111)(0.17412)]
1.05127
$100,000
[0.986788]
1.05127
$93,866.18
and the required risk spread or premium, , is:
⎛ 1⎞
k ( ) i ⎜
⎟⎠ ln[N (h2 ) (1/d )N (h1)]
⎝
( 1)ln[0.986788]
1.33%
Thus, the risky loan rate k( ) should be set at 6.33 percent when the risk-free rate (i) is
5 percent.
www.moodysanalytics.com
Theoretically, this model is an elegant tool for extracting premiums and default
probabilities. It also has important conceptual implications regarding which variables to focus on in credit risk evaluation [e.g., the firm’s market value of assets
(A) and asset risk ( 2)]. Even so, this model has a number of real-world implementation problems. Probably the most significant is the fact that neither the market
value of a firm’s assets (A) nor the volatility of the firm’s assets ( 2) is directly
observed.
The Moody’s Analytics Option Model and Expected Default Frequency The
Moody’s Analytics model in fact recognizes this problem by using an option pricing model (OPM) approach to extract the implied market value of assets (A) and
the asset volatility of a given firm’s assets ( 2). The Moody’s Analytics model uses
the value of equity in a firm (from a stockholder’s perspective) as equivalent to
holding a call option on the assets of the firm (with the amount of debt borrowed
acting similarly to the exercise price of the option). From this approach, and the
link between the volatility of the market value of the firm’s equity and that of its
assets, it is possible to derive the asset volatility (risk) of any given firm ( ) and
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Part Two
Measuring Risk
FIGURE 10–11
$
Frequency distribution
of asset values
at time 1
Expected Default
Frequency Using
the Moody’s
Analytics Model
Source: Moody’s Analytics.
www.moodysanalytics.com
+s
Asset
market
value
(A)
2s
Distance
from
default
Probability
of default
(EDF)
B
Contractual amount of current obligations
(default point)
0
1
Time
the market value of the firm’s assets (A).33 Using the implied value of for assets
and A, the market value of assets, the likely distribution of possible asset values of
the firm relative to its current debt obligations can be calculated over the next year.
As shown in Figure 10–11, the expected default frequency (EDF) that is calculated
reflects the probability that the market value of the firm’s assets (A) will fall below
the promised repayments on its short-term debt liabilities (B) in one year. If the
value of a firm’s assets falls below its debt liabilities, it can be viewed as being economically insolvent.
Suppose the value of the firm’s assets (A) at the time zero is $100 million and
the value of its short-term debt is $80 million. Suppose also that the implied volatility ( ) of asset values is estimated at $12.12 million, and it is assumed that assetvalue changes are normally distributed. The firm becomes distressed only if the
value of its assets falls to $80 million or below (falls by $20 million). Such a fall is
equal to 1.65 , i.e., 1.65 $12.12 million $20 million. From statistics, we know
that the area of the normal distribution (in each tail) lying 1.65 from the mean
is theoretically 5 percent. Thus, the Moody’s Analytics model would suggest a
theoretical 5 percent probability of the firm’s going into distress over the next year
(by time 1). However, Moody’s Analytics calculates empirical EDFs, since we do
not know the true distribution of asset values (A) over time. Essentially, it asks this
question: In practice, how many firms that started the year with asset values 1.65
distance from default (see Figure 10–11) actually defaulted by the end of the year?
This value may or may not equal 5 percent.
33
More specifically, it does this by using the equity (stock market) value of the firm’s shares (E) and the
volatility of the value of the firm’s shares ( E). Since equity can be viewed as a call option on the firm’s
assets and the volatility of a firm’s equity value will reflect the leverage adjusted volatility of its underlying
assets, we have in general form:
E f ( A, , B, r , )
and
E
g( )
where the bars denote values that are directly measurable. Since we have two equations and two
unknowns (A, ), we can directly solve for both A and and use these, along with the firm’s outstanding
short-term liabilities or current liabilities, to calculate the EDF (expected default frequency).
Chapter 10
FIGURE 10–12
Credit Risk: Individual Loan Risk
315
Moody’s Analytics EDF, Moody’s, and S&P Ratings for AMR Corporation
Source: Moody’s Analytics. www.moodysanalytics.com
S&P
Default Date: 11/29/2011
Moody’s
C
EDF %
38.00
36.00
AMR Corporation
34.00
CCC+
32.00
EDF
Ca
30.00
28.00
26.00
Caa3
24.00
22.00
Moody’s rating
Caa2
20.00
18.00
Caa1
16.00
S&P rating
B–
14.00
B3
12/11/10 1/16/11
2/21/11
3/29/11
5/4/11
6/9/11
7/15/11
8/20/11
9/25/11
10/31/11
Simulations by Moody’s Analytics have shown that EDF models outperform
both Z score–type models and S&P rating changes as predictors of corporate failure and distress.34 An example for AMR Corp., which filed for Chapter 11 bankruptcy protection on November 29, 2011, is shown in Figure 10–12. Note that the
Moody’s Analytics EDF score (expected default frequency) is rising earlier than
the rating agencies are downgrading the firm’s debt. Indeed, the rating agency
ratings are very slow to react to, if not totally insensitive to, the increase in AMR
Corp. risk. The Moody’s Analytics EDF score starts to rise almost a year prior to
AMR Corp. bankruptcy and suggests a C rating by July 2011. Thus, the Moody’s
Analytics EDF score gives a better early warning of impending default. In an
effort to get control over credit rating firms, that give high-quality ratings to highrisk firms, such as AMR, in April 2009 the Credit Rating Agency Reform Act was
passed. This act gave the SEC regulatory authority over credit rating firms and
was intended to increase competition and oversight of credit rating firms.
Concept
Questions
1. Which is the only credit risk model discussed in this section that is really forward looking?
2. How should the risk premium on a loan be affected if there is a reduction in a borrower’s leverage and the underlying volatility of its earnings?
3. What is the link between the implied volatility of a firm’s assets and its expected
default frequency?
34
The Moody’s Analytics database contains 30 years of information on more than 6,000 public and
220,000 private company default events for a total of 60,000 public and 2.8 million private companies,
healthy and distressed, around the world.
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Part Two
Measuring Risk
Summary
www.mhhe.com/saunders8e
Questions
and Problems
This chapter discussed different approaches to measuring credit or default risk
on individual loans (bonds). The different types of loans made by FIs and some
of their basic characteristics were first examined. The expected return on a loan
was shown to depend on factors such as origination fees, compensating balances,
interest rates, and maturity. The various models to assess default risk include both
qualitative and quantitative models. The qualitative models usually contain both
firm-specific factors, such as reputation and leverage, and market-specific factors,
such as the business cycle and the level of interest rates. Quantitative models, such
as the linear probability model, the logit model, and the linear discriminant model,
were shown to provide credit scores that can rank or classify loans by expected
default risk. The more rigorous of the quantitative models make use of both financial theory and financial data. These include the term structure and mortality rate
models as well as the RAROC (risk-adjusted return on capital) and option-based
models. In the next chapter we look at methods to evaluate the risk of loan portfolios, or loan concentration risk.
1. Why is credit risk analysis an important component of FI risk management?
What recent activities by FIs have made the task of credit risk assessment
more difficult for both FI managers and regulators?
2. Differentiate between a secured loan and an unsecured loan. Who bears most
of the risk in a fixed-rate loan? Why would FI managers prefer to charge floating rates, especially for longer-maturity loans?
3. How does a spot loan differ from a loan commitment? What are the advantages and disadvantages of borrowing through a loan commitment?
4. Why is commercial lending declining in importance in the United States?
What effect does this decline have on overall commercial lending activities?
5. What are the primary characteristics of residential mortgage loans? Why does
the ratio of adjustable-rate mortgages to fixed-rate mortgages in the economy
vary over an interest rate cycle? When would the ratio be highest?
6. What are the two major classes of consumer loans at U.S. banks? How do
revolving loans differ from nonrevolving loans?
7. Why are rates on credit cards generally higher than rates on car loans?
8. What are compensating balances? What is the relationship between the amount
of compensating balance requirement and the return on the loan to the FI?
9. Suppose that a bank does the following:
a. Sets a loan rate on a prospective loan at 8 percent (where BR 5% and 3%).
b. Charges a 1 10 percent (or 0.10 percent) loan origination fee to the borrower.
c. Imposes a 5 percent compensating balance requirement to be held as noninterestbearing demand deposits.
d. Holds reserve requirements of 10 percent imposed by the Federal Reserve
on the bank’s demand deposits.
Calculate the bank’s ROA on this loan.
10. County Bank offers one-year loans with a stated rate of 9 percent but requires
a compensating balance of 10 percent. What is the true cost of this loan to the
borrower? How does the cost change if the compensating balance is 15 percent? If the compensating balance is 20 percent? In each case, assume origination fees and the reserve requirement are zero.
Chapter 10
Credit Risk: Individual Loan Risk
317
PDi 0.105(D/Ai ) 0.35(PMi )
Prospective borrower A has a D/A 0.65 and a PM 5%, and prospective
borrower B has a D/A 0.45 and a PM 1%. Calculate the prospective borrowers’ expected probabilities of default (PDi). Which borrower is the better
loan candidate? Explain your answer.
20. Suppose the estimated linear probability model used by an FI to predict business loan applicant default probabilities is PD 0.03X1 0.02X2 0.05X3 error, where X1 is the borrower’s debt/equity ratio, X2 is the volatility of borrower earnings, and X3 is the borrower’s profit ratio. For a particular loan
applicant, X1 0.75, X2 0.25, and X3 0.10.
a. What is the projected probability of default for the borrower?
b. What is the projected probability of repayment if the debt/equity ratio is 2.5?
c. What is a major weakness of the linear probability model?
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11. Metrobank offers one-year loans with a 9 percent stated or base rate, charges a
0.25 percent loan origination fee, imposes a 10 percent compensating balance
requirement, and must hold a 6 percent reserve requirement at the Federal
Reserve. The loans typically are repaid at maturity.
a. If the risk premium for a given customer is 2.5 percent, what is the simple
promised interest return on the loan?
b. What is the contractually promised gross return on the loan per dollar lent?
c. Which of the fee items has the greatest impact on the gross return?
12. Why are most retail borrowers charged the same rate of interest, implying the
same risk premium or class? What is credit rationing? How is it used to control credit risks with respect to retail and wholesale loans?
13. Why could a lender’s expected return be lower when the risk premium is
increased on a loan? In addition to the risk premium, how can a lender increase
the expected return on a wholesale loan? A retail loan?
14. What are covenants in a loan agreement? What are the objectives of covenants? How can these covenants be negative? Positive?
15. Identify and define the borrower-specific and market-specific factors that enter
into the credit decision. What is the impact of each type of factor on the risk
premium?
a. Which of these factors is more likely to adversely affect small businesses
rather than large businesses in the credit assessment process by lenders?
b. How does the existence of a high debt ratio typically affect the risk of the
borrower?
c. Why is the volatility of the earnings stream of a borrower important to a lender?
16. Why is the degree of collateral as specified in the loan agreement of importance to
a lender? If the book value of the collateral is greater than or equal to the amount
of the loan, is the credit risk of a lender fully covered? Why or why not?
17. Why are FIs consistently interested in the expected level of economic activity
in the markets in which they operate? Why is monetary policy of the Federal
Reserve System important to FIs?
18. What are the purposes of credit scoring models? How do these models assist
an FI manager in better administering credit?
19. Suppose there were two factors influencing the past default behavior of borrowers: the leverage or debt–assets ratio (D/A) and the profit margin ratio (PM).
Based on past default (repayment) experience, the linear probability model is
estimated as:
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Part Two
Measuring Risk
21. Describe how a linear discriminant analysis model works. Identify and discuss the criticisms which have been made regarding the use of this type of
model to make credit risk evaluations.
22. Suppose that the financial ratios of a potential borrowing firm take the following values:
Working capital/total assets ratio (X1) 0.75
Retained earnings/total assets ratio (X2) 0.10
Earnings before interest and taxes/total assets ratio (X3) 0.05
Market value of equity/book value of long-term debt ratio (X4) 0.10
Sales/total assets ratio (X5) 0.65
Calculate the Altman’s Z-score for the borrower in question. How is this number a sign of the borrower’s default risk?
23. MNO Inc., a publicly traded manufacturing firm in the United States, has
provided the following financial information in its application for a loan. All
numbers are in thousands of dollars.
Assets
Cash
Accounts receivable
Inventory
$ 20
90
90
Plant and equipment
500
Total assets
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Liabilities and Equity
$700
Accounts payable
Notes payable
Accruals
Long-term debt
Equity (retained earnings $22)
$ 30
90
30
150
400
Total liabilities and equity
$700
Also assume sales $500,000; cost of goods sold $360,000; and the market
value of equity is equal to the book value.
a. What is the Altman discriminant function value for MNO Inc.? Recall
that:
Net working capital Current assets Current liabilities.
Current assets Cash Accounts receivable Inventories.
Current liabilities Accounts payable Accruals Notes payable.
EBIT Revenues Cost of goods sold.
b. Based on the Altman’s Z score only, should you approve MNO Inc.’s application to your bank for a $500,000 capital expansion loan?
c. If sales for MNO were $300,000, the market value of equity was only half
of book value, and all other values are unchanged, would your credit decision change?
d. Would the discriminant function change for firms in different industries?
Would the function be different for manufacturing firms in different geographic sections of the country? What are the implications for the use of
these types of models by FIs?
24. Consider the coefficients of Altman’s Z score. Can you tell by the size of the
coefficients which ratio appears most important in assessing creditworthiness
of a loan applicant? Explain.
Credit Risk: Individual Loan Risk
319
25. If the rate on one-year Treasury strips currently is 6 percent, what is the
repayment probability for each of the following two securities? Assume
that if the loan is defaulted, no payments are expected. What is the marketdetermined risk premium for the corresponding probability of default for
each security?
a. One-year AA-rated zero-coupon bond yielding 9.5 percent.
b. One-year BB-rated zero-coupon bond yielding 13.5 percent.
26. A bank has made a loan charging a base lending rate of 10 percent. It expects
a probability of default of 5 percent. If the loan is defaulted, the bank expects
to recover 50 percent of its money through the sale of its collateral. What is the
expected return on this loan?
27. Assume that a one-year Treasury strip is currently yielding 5.5 percent and an
AAA-rated discount bond with similar maturity is yielding 8.5 percent.
a. If the expected recovery from collateral in the event of default is 50 percent
of principal and interest, what is the probability of repayment of the AAArated bond? What is the probability of default?
b. What is the probability of repayment of the AAA-rated bond if the expected
recovery from collateral in the case of default is 94.47 percent of principal
and interest? What is the probability of default?
c. What is the relationship between the probability of default and the proportion of principal and interest that may be recovered in case of default on the
loan?
28. What is meant by the phrase marginal default probability? How does this term
differ from cumulative default probability? How are the two terms related?
29. Suppose an FI manager wants to find the probability of default on a two-year
loan. For the one-year loan, 1 p1 0.03 is the marginal and total or cumulative probability (Cp) of default in year 1. For the second year, suppose that
1 p2 0.05. Calculate the cumulative probability of default over the next
two years.
30. From the Treasury strip yield curve, the current required yields on one- and twoyear Treasuries are i1 4.65 percent and i2 5.50 percent, respectively. Further,
the current yield curve indicates that appropriate one-year discount bonds are
yielding k1 8.5 percent, and two-year bonds are yielding k2 10.25 percent.
a. Calculate the one-year forward rate on the Treasuries and the corporate bond.
b. Using the current and forward one-year rates, calculate the marginal probability of repayment on the corporate bond in years 1 and 2, respectively.
c. Calculate the cumulative probability of default on the corporate bond over
the next two years.
31. Calculate the term structure of default probabilities over three years using the
following spot rates from the Treasury strip and corporate bond (pure discount) yield curves. Be sure to calculate both the annual marginal and the
cumulative default probabilities.
Spot 1 Year
Treasury strip
BBB-rated bonds
5.0%
7.0
Spot 2 Year
6.1%
8.2
Spot 3 Year
7.0%
9.3
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Chapter 10
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32. The bond equivalent yields for U.S. Treasury and A-rated corporate bonds
with maturities of 93 and 175 days are given below:
93 Days
175 Days
Treasury strip
A-rated corporate
8.07%
8.42
8.11%
8.66
Spread
0.35
0.55
a. What are the implied forward rates for both an 82-day Treasury and an
82-day A-rated bond beginning in 93 days? Use daily compounding on a
365-day year basis.
b. What is the implied probability of default on A-rated bonds over the next
93 days? Over 175 days?
c. What is the implied default probability on an 82-day, A-rated bond to be
issued in 93 days?
33. What is the mortality rate of a bond or loan? What are some of the problems
with using a mortality rate approach to determine the probability of default of
a given bond issue?
34. The following is a schedule of historical defaults (yearly and cumulative) experienced by an FI manager on a portfolio of commercial and mortgage loans.
Years after Issuance
Loan Type
www.mhhe.com/saunders8e
Commercial:
Annual default
Cumulative default
Mortgage:
Annual default
Cumulative default
1 Year
2 Years
3 Years
4 Years
5 Years
0.00%
______
______
0.10%
0.50%
______
______
0.80%
0.30%
______
0.10%
______
0.25%
______
0.60%
______
______
1.64%
0.80%
______
a. Complete the blank spaces in the table.
b. What are the probabilities that each type of loan will not be in default after
five years?
c. What is the measured difference between the cumulative default (mortality)
rates for commercial and mortgage loans after four years?
35. The table below shows the dollar amounts of outstanding bonds and corresponding default amounts for every year over the past five years. Note that
the default figures are in millions, while those outstanding are in billions. The
outstanding figures reflect default amounts and bond redemptions.
Years after Issuance
Loan Type
A-rated: Annual default (millions)
Outstanding (billions)
B-rated: Annual default (millions)
Outstanding (billions)
C-rated: Annual default (millions)
Outstanding (billions)
1 Year
2 Years
3 Years
4 Years
5 Years
0
$100
0
$100
$ 1
$100
0
$95
$ 1
$94
$ 3
$97
0
$93
$ 2
$92
$ 5
$90
$ 1
$91
$ 3
$89
$ 5
$85
$ 2
$88
$ 4
$85
$ 6
$79
What are the annual and cumulative default rates of the above bonds?
Chapter 10
Credit Risk: Individual Loan Risk
321
Face value of loan (B) $500,000
Length of time remaining to loan maturity ( ) 4 years
Risk-free rate (i) 4%
Borrower’s leverage ratio (d) 60%
Standard deviation of the rate of change in the value of the underlying assets 15%
40. A firm is issuing a two-year loan in the amount of $200,000. The current market value of the borrower’s assets is $300,000. The risk-free rate is 4 percent
and the standard deviation of the rate of change in the underlying assets
of the borrower is 20 percent. Using an options framework, determine the
following:
a. The current market value of the loan.
b. The risk premium to be charged on the loan.
41. A firm has assets of $200,000 and total debts of $175,000. With an option pricing model, the implied volatility of the value of the firm’s assets is estimated
at $10,730. Under the Moody’s Analytic method, what is the expected default
frequency (assuming a normal distribution for assets)?
42. Carman County Bank (CCB) has a $5 million face value outstanding adjustablerate loan to a company that has a leverage ratio of 80 percent. The current riskfree rate is 6 percent and the time to maturity on the loan is exactly ½ year. The
asset risk of the borrower, as measured by the standard deviation of the rate of
change in the value of the underlying assets, is 12 percent. The normal density
function values are given below.
www.mhhe.com/saunders8e
36. What is RAROC? How does this model use the concept of duration to measure the risk exposure of a loan? How is the expected change in the credit risk
premium measured? What precisely is ΔLN in the RAROC equation?
37. An FI wants to evaluate the credit risk of a $5 million loan with a duration of
4.3 years to a AAA borrower. There are currently 500 publicly traded bonds
in that class (i.e., bonds issued by firms with a AAA rating). The current average level of rates (R) on AAA bonds is 8 percent. The largest increase in credit
risk premiums on AAA loans, the 99 percent worst-case scenario, over the
last year was equal to 1.2 percent (i.e., only 6 bonds out of 500 had risk premium increases exceeding the 99 percent worst case). The projected (oneyear) spread on the loan is 0.3 percent and the FI charges 0.25 percent of the
face value of the loan in fees. Calculate the capital at risk and the RAROC on
this loan.
38. A bank is planning to make a loan of $5,000,000 to a firm in the steel industry.
It expects to charge a servicing fee of 50 basis points. The loan has a maturity of 8 years with a duration of 7.5 years. The cost of funds (the RAROC
benchmark) for the bank is 10 percent. The bank has estimated the maximum
change in the risk premium on the steel manufacturing sector to be approximately 4.2 percent, based on two years of historical data. The current market
interest rate for loans in this sector is 12 percent.
a. Using the RAROC model, determine whether the bank should make the
loan.
b. What should be the duration in order for this loan to be approved?
c. Assuming that the duration cannot be changed, how much additional
interest and fee income will be necessary to make the loan acceptable?
d. Given the proposed income stream and the negotiated duration, what
adjustment in the loan rate would be necessary to make the loan acceptable?
39. Calculate the value of and interest rate on a loan using the option model and
the following information.
322
Part Two
Measuring Risk
h
N(h)
h
N(h)
2.55
2.60
2.65
2.70
2.75
0.0054
0.0047
0.0040
0.0035
0.0030
2.50
2.55
2.60
2.65
2.70
0.9938
0.9946
0.9953
0.9960
0.9965
a. Use the Merton option valuation model to determine the market value of
the loan.
b. What should be the interest rate for the last six months of the loan?
The questions and problems that follow refer to Appendix 10A.
43. Suppose you are a loan officer at Carbondale Local Bank. Joan Doe listed the
following information on her mortgage application.
Characteristic
Annual gross income
TDS
Relations with FI
Major credit cards
Age
Residence
Length of residence
Job stability
Credit history
Value
$45,000
10%
Checking account
5
27
Own/mortgage
2½ years
5½ years
Missed 2 payments 1 year ago
Use the information below to determine whether or not Joan Doe should be
approved for a mortgage from your bank.
www.mhhe.com/saunders8e
Characteristic
Characteristic Values and Weights
Annual gross
$25,000–$50,000
$50,000–$100,000 $100,000
$10,000 $10,000–$25,000
income
Score
0
10
20
35
60
TDS
35%–50%
15%–35%
5%–15%
50%
5%
Score
0
20
40
60
10
Relations with FI
None
Checking account
Savings account
Both
Score
0
10
10
20
Major credit cards
None
Between 1 and 4
5 or more
Score
0
20
10
Age
25–60
25
60
Score
5
25
35
Residence
Rent
Own with mortgage
Own outright
Score
5
20
50
Length of
1–5 years
1 year
5 years
residence
Score
0
25
40
Job stability
1–5 years
1 year
5 years
Score
0
25
50
Credit history
No record Missed a payment in last 5 years Met all payments
Score
0
40
15
Chapter 10
Credit Risk: Individual Loan Risk
323
The loan is automatically rejected if the applicant’s total score is less than or equal to
120; the loan is automatically approved if the total score is greater than or equal to
190. A score between 120 and 190 (noninclusive) is reviewed by a loan committee for
a final decision.
44. What are some of the special risks and considerations when lending to small
businesses rather than large businesses?
45. How does ratio analysis help to answer questions about the production, management, and marketing capabilities of a prospective borrower?
46. Consider the following company balance sheet and income statement.
Balance Sheet
Assets
Cash
Accounts receivable
Inventory
Total current assets
Fixed assets
Total assets
Liabilities and Equity
$
4,000
52,000
40,000
96,000
44,000
$140,000
Accounts payable
Notes payable
Total current liabilities
Long-term debt
Equity
Total liabilities and equity
$ 30,000
12,000
42,000
36,000
62,000
$140,000
Income Statement
$200,000
130,000
70,000
20,000
8,000
42,000
4,800
37,200
11,160
$ 26,040
For this company, calculate the following:
a. Current ratio.
b. Number of days’ sales in receivables.
c. Sales to total assets.
d. Number of days in inventory.
e. Debt to assets ratio.
f. Cash flow to debt ratio.
g. Return on assets.
h. Return on equity.
47. Industrial Corporation has an income to sales (profit margin) ratio of 0.03, a
sales to assets (asset utilization) ratio of 1.5, and a debt to asset ratio of 0.66.
What is Industrial’s return on equity?
Web Questions
48. Go to the Federal Reserve Board’s website at www.federalreserve.gov and
update the data in Table 10–1 using the following steps. Click on “All Statistical Releases.” Click on “Assets and Liabilities of Commercial Banks in the
www.mhhe.com/saunders8e
Sales (all on credit)
Cost of goods sold
Gross margin
Selling and administrative expenses
Depreciation
EBIT
Interest expense
Earning before tax
Taxes
Net income
324
Part Two
Measuring Risk
U.S.” This downloads a file onto your computer that contains the relevant
data. How has the data changed since that reported in Table 10–1 for 2012?
49. Go to the Federal Housing Finance Agency’s website at www.fhfa.gov and
find the most recent data on the percentage of conventional single-family
mortgages with adjustable rates using the following steps. Under “Research
& Analysis,” then “Market Data,” and then “Monthly Interest Rate Survey
Data,” click on “Historical Summary Tables.” Click on “Annual, All Homes,
1963–20XX.” This downloads a file onto your computer that contains the relevant data. How has this data changed since 2012?
50. Go to the Federal Reserve Board’s website at www.federalreserve.gov and
update Table 10–7 using the following steps. Click on “All Statistical Releases.”
Click on “Consumer Credit.” This downloads a file onto your computer that
contains the relevant data. How have consumer loan rates changed since 2012
as reported in Table 10–7?
Integrated Mini Case
LOAN ANALYSIS
As a senior loan officer at MC Bancorp, you
have the following loan applications waiting for
review. The bank uses Altman’s Z score, default
probabilities, mortality rates, and RAROC to
assess loan acceptability. The bank’s cost of equity
(the RAROC benchmark) is 9 percent. The bank’s
loan policy states that the maximum probability
of default for loans by type is as follows:
Loan Type and
Maturity
Maximum Allowable
Default Probability
www.mhhe.com/saunders8e
AAA-rated
A-rated
0.50%
1.25
Which loans should be approved and which
rejected?
Assets
1. An AAA-rated, one-year C&I loan from a firm
with a liquidity ratio of 2.15, a debt-to-asset
ratio of 45 percent, volatility in earnings of 0.13,
and a profit margin of 12 percent. MC Bancorp
uses a linear probability model to evaluate
AAA-rated loans as follows:
PD 0.08X 1 0.15X 2 1.25X 3 0.45 X 4
where
X1 Liquidity ratio
X2 Debt-to-asset ratio
X3 Volatility in earnings
X4 Profit margin
2. An AA-rated, one-year C&I loan from a firm
with the following financial statement information (in millions of dollars):
Liabilities and Equity
Cash
Accounts receivables
Inventory
$
40
120
210
Plant and equipment
Total assets
1,100
$1,470
Also assume sales $1,250 m, cost of goods sold
$930 m, and the market value of equity is equal
Accounts payable
Notes payable
Accruals
Long-term debt
Equity (ret. earnings $200)
Total liabilities and equity
$
55
60
70
550
735
$1,470
to 2.2 times the book value. MC Bancorp uses the
Altman’s Z score model to evaluate AA-rated loans.
Chapter 10
3. An A-rated corporate loan with a maturity
of three years. A-rated corporate loans are
evaluated using the mortality rate approach.
Credit Risk: Individual Loan Risk
325
A schedule of historical defaults (annual and
cumulative) experienced by the bank on its
A-rated corporate loans is as follows:
Years after Issuance
1 year
2 years
3 years
4 years
0.10%
0.10
0.25%
0.325
0.40%
0.595
0.65%
1.858
4. A $2 million, five-year loan to a BBB-rated corporation in the computer parts industry. MC
Bancorp charges a servicing fee of 75 basis
points. The duration on the loan is 4.5 years.
The cost of funds for the bank is 8 percent.
Based on four years of historical data, the bank
has estimated the maximum change in the risk
premium on the computer parts industry to be
approximately 5.5 percent. The current market
rate for loans in this industry is 10 percent.
Appendix 10A: Credit Analysis
View Appendix 10A at the website for this textbook (www.mhhe.com/saunders8e).
Appendix 10B: Black–Scholes Option Pricing Model
View Appendix 10B at the website for this textbook (www.mhhe.com/saunders8e).
www.mhhe.com/saunders8e
Loan type
A-rated corporate loans
Annual default
Cumulative default
Chapter Eleven
Credit Risk: Loan
Portfolio and
Concentration Risk
INTRODUCTION
www.naic.org
The models discussed in the previous chapter describe alternative ways by which
an FI manager can measure the default risks on individual debt instruments such
as loans and bonds. Rather than looking at credit risk one loan at a time, this chapter concentrates on the ability of an FI manager to measure credit risk in a loan
(asset) portfolio context and the benefit from loan (asset) portfolio diversification.
We discuss and illustrate several models that are used by FI managers to assess
the risk of the overall loan portfolio. The risk-return characteristics of each loan in
the portfolio are a concern for the FI, but the risk-return of the overall loan portfolio, with some of the risk of the individual loans diversified, affects an FI’s overall
credit risk exposure. Additionally, we look at the potential use of loan portfolio
models in setting maximum concentration (borrowing) limits for certain business
or borrowing sectors (e.g., sectors identified by their Standard Industrial Classification [SIC] codes).
This chapter also discusses regulatory methods for measuring default risk of a
portfolio. In particular, the FDIC Improvement Act of 1991 required bank regulators to incorporate credit concentration risk into their evaluation of bank insolvency risk. Moreover, a debate currently is being conducted among bankers and
regulators about how this can be done. Some banks are allowed to use their own
internal models, such as CreditMetrics and CreditRisk (discussed in the Appendices to this chapter) and Moody’s Analytics Portfolio Manager (discussed later
in this chapter), to calculate their capital requirements against insolvency risk
from excessive loan concentrations. Further, the National Association of Insurance
Commissioners (NAIC) has developed limits for different types of assets and borrowers in insurers’ portfolios—a so-called pigeonhole approach.
SIMPLE MODELS OF LOAN CONCENTRATION RISK
FIs widely employ two simple models to measure credit risk concentration in the
loan portfolio beyond the purely subjective model of “We have already lent too
326
Chapter 11
TABLE 11–1
A Hypothetical
Rating Migration, or
Transition, Matrix
Credit Risk: Loan Portfolio and Concentration Risk
327
Risk Rating at End of Year
Risk Rating at
Beginning of Year
AAA-A
BBB-B
CCC-C
AAA-A
0.85
0.12
0.03
BBB-B
0.10
0.83
0.13
CCC-C
0.04
0.03
0.80
D*
0.01
0.02
0.04
*D default.
migration analysis
A method to measure
loan concentration
risk by tracking credit
ratings of firms in
a particular sector
or ratings class for
unusual declines.
www.standardandpoors.com
www.moodys.com
loan migration
matrix
A measure of the
probability of a loan
being upgraded,
downgraded, or
defaulting over some
period.
concentration limits
External limits set
on the maximum
loan size that can be
made to an individual
borrower.
much to this borrower.” The first is migration analysis, where lending officers
track S&P, Moody’s, or their own internal credit ratings of certain pools of loans
or certain sectors—for example, machine tools. If the credit ratings of a number
of firms in a sector or rating class decline faster than has been historically experienced, FIs curtail lending to that sector or class.
A loan migration matrix (or transition matrix) seeks to reflect the historic
experience of a pool of loans in terms of their credit rating migration over time.
As such, it can be used as a benchmark against which the credit migration patterns of any new pool of loans can be compared. Table 11–1 shows a hypothetical
credit migration matrix, or table, in which loans are assigned to one of three rating classes (most FIs use 10 to 13 rating classes). The rows in Table 11–1 list the
S&P rating at which the portfolio of loans began the year and the columns list the
rating at which the portfolio ended the year. The numbers in the table are called
transition probabilities, reflecting the average experience (proportions) of loans that
began the year, say, as rating BB remaining rating BB at the end of the year, being
upgraded to an AA, being downgraded to a CC, or defaulting (D).
For example, for loans that began the year at rating BBB-B, historically (on average) 12 percent have been upgraded to AAA-A, 83 percent have remained at BBB-B,
3 percent have been downgraded to CCC-C, and 2 percent have defaulted by
the end of the year. Suppose that the FI is evaluating the credit risk of its current
portfolio of loans of borrowers rated BBB-B and that over the last few years a much
higher percentage (say, 5 percent) of loans has been downgraded to CCC-C and
a higher percentage (say, 3 percent) has defaulted than is implied by the historic
transition matrix. The FI may then seek to restrict its supply of lower-quality loans
(e.g., those rated BBB-B and CCC-C), concentrating more of its portfolio on grade
AAA-A loans. At the very least, the FI should seek higher credit risk premiums on
lower-quality (rated) loans. Not only is migration analysis used to evaluate commercial loan portfolios, it is widely used to analyze credit card portfolios and consumer loans as well.
The second simple model requires management to set some firm external limit
on the maximum amount of loans that will be made to an individual borrower
or sector. The FI determines concentration limits on the proportion of the loan
portfolio that can go to any single customer by assessing the borrower’s current
portfolio, its operating unit’s business plans, its economists’ economic projections,
and its strategic plans. Typically, FIs set concentration limits to reduce exposures
to certain industries and increase exposures to others. When two industry groups’
performances are highly correlated, an FI may set an aggregate limit of less than
the sum of the two individual industry limits. FIs also typically set geographic
limits. They may set aggregate portfolio limits or combinations of industry and
geographic limits. Bank regulators in recent years have limited loan concentrations to individual borrowers to a maximum of 10 percent of a bank’s capital.
328
Part Two
Measuring Risk
EXAMPLE 11–1
Calculating
Concentration
Limits for a Loan
Portfolio
Suppose management is unwilling to permit losses exceeding 10 percent of an FI’s capital
to a particular sector. If management estimates that the amount lost per dollar of defaulted
loans in this sector is 40 cents, the maximum loans to a single sector as a percent of capital,
defined as the concentration limit, is:
Concentration limit Maximum loss as a percent of capital 1
Loss rate
10% (1/0.4)
25%
Concept
Questions
1. In Example 11–1, what would the concentration limit be if the loss rate on bad loans
is 25 cents on the dollar? (40%)
2. In Example 11–1, what would the concentration limit be if the maximum loss (as a
percent of capital) is 15 percent instead of 10 percent? (60%)
Next we look at the use of more sophisticated portfolio theory–based models
to set concentration limits. While these models have a great deal of potential, data
availability and other implementation problems have, until recently, hindered
their use. The basic idea is to select the portfolio of loans that maximizes the return
on the loan portfolio for any given level of risk (or that minimizes the degree of
portfolio risk for any given level of returns).
LOAN PORTFOLIO DIVERSIFICATION AND MODERN
PORTFOLIO THEORY (MPT)
To the extent that an FI manager holds widely traded loans and bonds as assets or,
alternatively, can calculate loan or bond returns, portfolio diversification models
can be used to measure and control the FI’s aggregate credit risk exposure. Suppose the manager can estimate the expected return of each loan or bond (Ri ) in the
FI’s portfolio.
After calculating the individual security return series, the FI manager can compute the expected return (Rp) on a portfolio of assets as:
Rp N
∑ Xi Ri
(1)
i 1
In addition, the variance of returns or risk of the portfolio ( i2 ) can be calculated as:
n
n
n
∑ Xi2 i2 ∑
p2 i 1
∑ Xi X j ij
(2)
i 1 j 1
i≠ j
or
p2 n
n
n
∑ Xi2 i2 ∑ ∑ Xi X jρij i j
i=1
i 1 j 1
i j
(3)
Chapter 11
Credit Risk: Loan Portfolio and Concentration Risk
329
where
Rp Expected or mean return on the asset portfolio
Summation sign
Ri return on the ith asset in the portfolio
Xi Proportion of the asset portfolio invested in the ith asset (the desired
concentration amount)
i2 = of returns on the ith asset
ij Covariance of returns between the ith and jth assets
ij Correlation between the returns on the ith and jth assets1
The fundamental lesson of modern portfolio theory (MPT) is that by taking
advantage of its size, an FI can diversify considerable amounts of credit risk as
long as the returns on different assets are imperfectly correlated with respect to
their default risk adjusted returns.2
Consider the p2 in equation (3). If many loans have negative correlations of
returns (ij are negative)—that is, when one borrower’s loans do badly and another’s do well—then combining loans to both borrowers may reduce the FI’s overall credit risk exposure. That is, if there is negative correlation across borrower
default probabilities, then a portfolio of loans may have less risk than an individual loan, all else equal. Thus, the sum of the individual credit risks of loans
viewed independently overestimates the risk of the whole portfolio. Because correlation is constrained to lie between plus and minus one, we can evaluate the
effect of a change in ij on asset portfolio risk. For example, in the two-asset case, if
ij is negative, the second term in equation (3) will also be negative and will offset
the first term, which will always be positive. By appropriately exploiting correlation relationships among assets, an FI can significantly reduce risk in the asset
portfolio and improve the portfolio’s risk-return trade-off. This is what we meant
in Chapter 1 when we stated that by pooling funds, FIs can reduce risk by taking
advantage of the law of large numbers in their investment decisions.
EXAMPLE 11–2
Calculation of
Return and Risk
on a Two-Asset
Portfolio
Suppose that an FI holds two loans with the following characteristics:3
1
Loan i
Xi
Ri
i
i2
1
2
0.40
0.60
10%
12
0.0857
0.0980
0.007344
0.009604
12 0.84
12 0.0070548
The correlation coefficient reflects the joint movement of asset returns, or default risks in the case of
loans, and lies between the values 1 1, where is the correlation coefficient. As can be seen
from equations (2) and (3), the covariance between any two assets (ij) is related to the correlation coefficient (ij) by ij ijij.
2
One objection to using modern portfolio theory for loans is that the returns on individual loans are not
normally or symmetrically distributed. In particular, most loans have limited upside returns and long-tail
downside risks; see Appendix 11A and Chapter 9 in Saunders and Allen, Credit Risk Management: In and
Out of the Financial Crisis, 3rd ed. (New York: John Wiley & Sons, 2010). Also, concerns about maintaining relationships with traditional customers may limit the ability of an FI to diversify. The relationship limit
on diversification has been called the “paradox of credit.” That is, leading institutions specialize in monitoring and generating information about their key customers (see Chapter 1), yet such monitoring specialization may lead to a highly concentrated loan portfolio. Relationship concerns may inhibit the loan
portfolio’s being managed in a fashion similar to a mutual fund’s management of an equity portfolio.
3
Note that variance (2) is measured in percent squared; standard deviation () is measured in percent.
330
Part Two
Measuring Risk
The return on the loan portfolio is:
Rp 0.4(10%) 0.6(12%) 11.2%
while the risk of the portfolio is:
2
2
2
σ p (0.4) (0.007344) (0.6) (0.009604) 2(0.4)(0.6)( 0.84)(0.0857)(0.0980) 0.0012462
thus, σ p 0.0012462 0.0353 3.53%
Notice that the risk (or standard deviation of returns) of the portfolio, p (3.53 percent), is
less than the risk of either individual asset (8.57 percent and 9.80 percent, respectively). The
negative correlation between the returns of the two loans ( 0.84) results in an overall reduction of risk when they are put together in an FI’s portfolio.
minimum risk
portfolio
Combination of assets
that reduces the risk of
portfolio returns to the
lowest feasible level.
FIGURE 11–1
FI Portfolio
Diversification
To see more generally the advantages of diversification, consider Figure 11–1.
Note that A is an undiversified portfolio with heavy investment concentration in
just a few loans or bonds. By fully exploiting diversification potential with bonds
or loans whose returns are negatively correlated or that have a low positive correlation with those in the existing portfolio, the FI manager can lower the credit risk
on the portfolio from pA to pB while earning the same expected return. That is,
portfolio B is the efficient (lowest-risk) portfolio associated with portfolio return
level Rp. By varying the proportion of the asset portfolio invested in each asset (in
other words, by varying the required portfolio return level Rp up and down), the
manager can identify an entire frontier of efficient portfolio mixes (weights) of
loans and bonds. Each portfolio mix is efficient in the sense that it offers the lowest
risk level to the FI manager at each possible level of portfolio returns. However, as
you can see in Figure 11–1, of all possible efficient portfolios that can be generated,
portfolio B produces the lowest possible risk level for the FI manager. That is, it
maximizes the gains from diversifying across all available loans and bonds so that
the manager cannot reduce the risk of the portfolio below pB. For this reason, pB
is usually labeled the minimum risk portfolio.
Even though B is clearly the minimum risk portfolio, it does not generate
the highest returns. Consequently, portfolio B may be chosen only by the most
Rp
(return)
C
B
Rp
0
A
σpB
σpA
σp(risk)
Chapter 11
Credit Risk: Loan Portfolio and Concentration Risk
331
risk-averse FI managers, whose sole objective is to minimize portfolio risk regardless of the portfolio’s return. Most portfolio managers have some desired return-risk
trade-off in mind; they are willing to accept more risk if they are compensated with
higher expected returns. One such possibility would be portfolio C in Figure 11–1.
This is an efficient portfolio in that the FI manager has selected loan proportions
(Xi) to produce a portfolio risk level that is a minimum for that higher expected
return level. This portfolio dominates all other portfolios that can produce the same
expected return level.4
Portfolio theory is a highly attractive tool. Still, over and above the intuitive
concept that diversification is generally good, a question arises as to its applicability for banks, insurance companies, and thrifts. These FIs often hold significant
amounts of regionally specific nontraded or infrequently traded loans and bonds.
Concept
Questions
www.moodysanalytics.com
Moody’s Analytics
Portfolio Manager
A model that applies
modern portfolio
theory to the loan
portfolio.
1. What is the main point in using MPT for loan portfolio risk?
2. Why would an FI not always choose to operate with a minimum risk portfolio?
Moody’s Analytics Portfolio Manager Model
Despite the nontraded aspect of many loans, a great deal of recent research has
gone into developing modern portfolio theory models for loans. Below we look
at one approach developed by KMV Corporation (now owned and operated by
Moody’s Analytics) called Portfolio Manager.5 We will see that Moody’s Analytics
Portfolio Manager model differs from MPT in that it does not require loan returns
to be normally distributed. Further, Moody’s Analytics has developed a proprietary model to estimate the value of infrequently traded loans. Thus, the Moody’s
Analytics model is unique in the way it estimates the return, risk, and correlations
between loans in an FI’s loan portfolio. Once these variables are estimated in the
Moody’s Analytics Portfolio Manager model, they are then incorporated into the
standard MPT equations to get an estimate of the risk and return of the FI’s loan
portfolio. The Moody’s Analytics Credit Monitor model examines Moody’s Analytics’ method of evaluating default risk on an individual loan (so-called expected
default frequency, or EDF). The Moody’s Analytics Portfolio Manager model,
examined in this chapter, uses the default probability on each loan in a portfolio to
identify the overall risk of the portfolio.
Any model that seeks to estimate an efficient frontier for loans, as in Figure 11–1,
and thus the optimal or best proportions (Xi) in which to hold loans made to different borrowers, needs to determine and measure three things [see equations (1),
(2), and (3)]: the expected return on a loan to borrower i (Ri), the risk of a loan to
borrower i (i), and the correlation of default risks between loans made to borrowers i and j (ij). Specifically, in the Moody’s Analytics Portfolio Manager model
4
Rather than selecting a point on the loan efficient frontier that reflects managerial risk aversion, as in
Figure 11–1, point C, the FI manager would pick a point that maximizes firm value. This would be the
point where the return of the portfolio minus the risk-free rate divided by the standard deviation of portfolio returns is maximized, that is, the maximum of [(Rp Rf)/p)]. In MPT this is often called the Sharpe
ratio. Diagramatically, this is a point on the efficient frontier where a straight line drawn from the vertical
axis, from a point equal to Rf, is just tangential to the efficient frontier. At this tangency point, it is impossible to improve upon the risk-return trade-off.
5
Other portfolio models have been developed, including CreditMetrics, CreditRisk, and Credit Portfolio
View (McKinsey and Company). See Saunders and Allen, Credit Risk Management.
332
Part Two
Measuring Risk
portfolio return and risk are a function of the extent to which loan (exposure) values
can change over a one-year horizon and how these value changes move together
across different loans in the loan portfolio (correlations). Changes in loan values are
determined by changes in the borrower’s credit quality (measured as the expected
default frequency [EDF], discussed in Chapter 10) and the amount of the loan not
recovered (i.e., the loss given default [LGD] on the loan). To calculate correlations,
Moody’s Analytics considers the joint impact of 120 different systematic factors,
which reflect the global economy, region, industry, and country.
In its simplest form, Moody’s Analytics measures each of these as follows:
Ri AISi
E(Li ) AISi
i ULi Di LGDi [EDFi LGDi ]
EDFi (1
EDFi ) LGDi
ij Correlation between the systematic return components
of the asset returns of borrower i and borrower j
(4)
(5)
Each of these needs some explanation.
Return on the Loan (Ri)
The return on a loan is measured by the so-called annual all-in-spread (AIS),
which measures annual fees earned on the loan by the FI plus the annual spread
between the loan rate paid by the borrower and the FI’s cost of funds. Deducted
from this is the expected loss on the loan [E(Li)]. This expected loss is equal to the
product of the expected probability of the borrower defaulting over the next year,
or its expected default frequency (EDFi)—as discussed in Chapter 10—times the
amount lost by the FI if the borrower defaults (the loss given default, or LGDi).
Also, if desired, the return on the loan can be expressed in excess return form by
deducting the risk-free rate on a security of equivalent maturity.
We looked at Altman’s estimates of recovery rates (1–LGD) on defaulted bonds
in Chapter 10. Altman’s research consistently finds that approximately 90 percent of
bond recovery rates can be explained and estimated using regressions that include
default rates on bonds, one-year changes in bond default rates, and the amount of
high yield bonds outstanding in a particular year (which represents the potential
supply of defaulted bonds). Macroeconomic factors are found to be insignificant
in explaining recovery rates on defaulted bonds (much of this effect is captured
in bonds default rates).6 Different types of debt instruments have different recovery rates. For example, more senior securities tend to have higher recovery rates
than subordinated securities, all else equal. Moody’s Analytics research has found
that the highest (lowest) LGD is for preferred stock and junior subordinated bonds
(industrial revenue bonds, senior secured bonds, and senior secured loans). The
Basel Committee assessed a fixed 45 percent LGD on secured loans if fully secured
by physical, non-real estate collateral and 40 percent if fully secured by receivables.
However, there is evidence suggesting that these fixed LGD rates may be too high
for bank loans.
Risk of the Loan (i)
The risk of the loan reflects the volatility of the loan’s default rate (Di) around
its expected value times the amount lost given default (LGDi). The product of
6
See E. Altman, “Loss Given Default: The Link between Default and Recovery Rates, Recovery Ratings
and Recent Empirical Evidence,” New York University Salomon Center Working Paper, May 2008.
Chapter 11
Credit Risk: Loan Portfolio and Concentration Risk
FIGURE 11–2
333
Firm
risk
Moody’s Analytics
Asset Level
Correlation
Systematic
risk
Industry
risk
Industry
specific
risk
Global
economic
risk
Firm
specific
risk
Country
risk
Regional
risk
Industrial
specific
risk
Country
specific
risk
the volatility of the default rate and the LGD is called the unexpected loss on the
loan (ULi) and is a measure of the loan’s risk, or i. To measure the volatility of
the default rate, assume that loans can either default or repay (no default). Then
defaults are binomially distributed, and the standard deviation of the default
rate for the ith borrower (Di) is equal to the square root of the probability of
default times 1 minus the probability of default [ (EDF )(1 EDF )].
Correlation (ij)
To measure the unobservable default risk correlation between any two borrowers, the Moody’s Analytics Portfolio Manager model uses the systematic asset
return components of the two borrowers—as discussed i